mindset and rationale for decisions that impactand motivate both trade entry and exit. This actual trade scenarioillustrates many of the rules we have covered thus far and helpsconvey what must be followed at all times.I was long and heavy in Amgen (AMGN) to the tune of10,000 shares, which I scaled into over the course of 2 days. Mycriteria for entering the trade was based on two key tradingranges that AMGN was trading within over the course of 10 days.I had been actively day trading the stock long and short duringthis 10-day period, and I would never have seen the patterns thatrevealed themselves had I not been day trading the stock every103
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day. I think I saw every tick and print in AMGN during thisperiod, and I began to form a clear idea of its price levels basedon my active trading experiences with it. Through day trading,I knew where the stock was “hot” and where it would “cool”down, in terms of the price levels of support and resistance. Ibelieved that if the stock could hold certain price levels, it wouldlikely break out hard, making a higher high, then come in a bit,making a higher low, and then make a higher high once again.As these levels were day traded, I could also feel the liquidity at certain prices to detect the strength and weakness of certainmarket makers over the course of days. From the microtradingapproach of day trading, I also could not help but form a broaderswing trade feel for the stock as well. I had been net positive inthe 10 days of day trading, but as time went on, I was gettingprogressively more and more profitable since my instincts forAMGN grew keener as the result of my strong activity in thestock. As my profits grew, so did my confidence, but not to thepoint of becoming cocky or overconfident; I simply felt I hadgreater clarity as the days passed for these key levels. On theeleventh day, I told myself that if AMGN pulled back to 563⁄8 (itwas trading at 583⁄4 at the time), I would press heavy into thestock since I knew the range around 563⁄8 was a strong supportlevel based on the patterns revealed in the preceding days. Sureenough, after remaining patient, the stock came in, and I purchased 3000 shares between 563⁄8 and 563⁄4. My expectation forprofit was 21⁄2 points based on the consistent honest range it hadshown me time and time again during the previous 10 days. Ialso felt if AMGN could break 59, it would break higher andlikely make a new higher high and a new 52-week high as well. Idecided that not only would I not liquidate my 3000-share position but also I would lean even heavier into it, if this occurred. At591⁄4, I watched AMGN catch on fire, and I purchased 5000 additional shares between 591⁄4 and 603⁄8. Within the next two hours,AMGN pulled back to 59 and acted very strong during this pullback. That may sound contradictory, but relative to the biotechsector, NASDAQ, and the futures at that time, AMGN was verystrong (relative strength). The biotech sector pulled back almosttwice as much as AMGN did and indicated AMGN had great support. I bought another 2000 shares at 59, buying weakness, meaning that I bid for the stock at the bid price level on the Level II
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and let sellers hit my bid. I was able to save the spread because Iprovided liquidity to the market by bidding for stock while therewere still sellers in the market. The point here is that I knewwhere I wanted in and didn’t mind buying some stock at thisprice. I also felt there was good subscription from two marketmakers who were net buyers for the day and who were also buying weakness at that time (shadowing the ax market makers).In the next two days, the NASDAQ continued to sell off byover 110 points, and AMGN never broke down through 59. Iknew my stock was acting strong in the face of a minor two-daytech selloff, and I let my position stand, knowing that if AMGNcould hold this level, it would advance quickly relative to themarket, once the market took off. Additionally, economic newswas being released, and an FOMC meeting was being held withan expected 50-basis-point rate hike. I felt that the rate hike hada strong chance of moving only 25 basis points higher and that ifI were right, the market would surely surge. Additionally, I hadalready had some unrealized profit in AMGN and had someroom to work with if the market responded poorly to the economic news and if the rate hike exceeded 50 basis points. Yousee, the selloff in the market the preceding few days was alreadybuilding in the expectation of a 50-basis-point rate increase;therefore, even if that had been the case, I felt there would bemore upside bias than downside bias since once again the market had begun correcting for it in advance of the FOMC news (themarket trading ahead of news). If it increased only 25 basispoints, I had tremendous upside potential; therefore, my speculative risk was a low-risk–high-reward spectrum, since I waslong a stock with good relative strength within its group and sector. The combined market condition, as I just noted, includingmy unrealized profit in AMGN, gave me strong conviction to letmy trade work and wait for the news to release.Sure enough, the FOMC increased rates by only 25 basispoints, even though I was comfortable with a 50-basis-point hikerelative to my position. AMGN ran 7 points that very day, and Ibegan to sell into strength taking my profits when it was uparound $5, scaling out completely when it was up around 53⁄4 at 65.While my story is a good one in this case, it cemented onceagain in my mind how rewarding the market is when you knowwhy you are in a trade and when you should be out. My day trad-
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ing activity highlighted this swing trade to me based on my pricelevel recognition. Having a broad view of the market as well asmy bias for the stock relative to its industry and index furtherconfirmed the reason I stayed with the trade. While I did not sellthe perfect top when AMGN traded up 7 the day I sold, I soldinto strength for a good bit of the move and never regretted it fora second! The moral of the story is also the rule: Know why youare in a trade, and where you will exit.While not all trades are winners such as this one, and I feelcompelled to share a few hard lessons I have learned—the storyillustrates how exit points can be determined. Had AMGN soldoff even near 58, I would have leveled the entire position andcontrolled the downside risk. Knowing where key levels are inprice and more importantly market psychology will more determine exit points than any other factor. Paying attention to thiswill naturally guide you to letting profits run while cuttinglosses quickly, hence allowing the market to lead you in and outof trades.A final point regarding this trade. While my position waslarge for a swing trade, I averaged my winners as AMGN rallied,which afforded me more risk tolerance. Additionally, because ofthe discipline I have, I was prepared to exit the trade at a predetermined price level.
MECHANICAL EXIT STRATEGIESThe often-asked question “When is the right time to exit atrade?” is best answered not only through the numbers and thedata the market presents through the tools but also through theinterpretive skills a trader possesses.The speed and ease of market access today often lead tospontaneous trading, which can be a fatal mistake. Fools rush in,and in today’s environment with the ability to bypass brokersand trade the hot technology sector, greed and gambling havebecome commonplace. I often ask traders “Where is the liquidityat the moment? If you had to get out of this trade fast, how wouldyou do it?” “What price is your threshold for pain?” If I do not getsolid answers like “I have Island’s book up and it’s stacked with
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buyers!” or “Look at the Level II, the ax is buying everything insight!” I give them our stop-loss/liquidity talk. It is imperativethat traders know where they are right and wrong about a tradebefore they enter it, and they must have the mechanics to findliquidity for a fast exit should that become necessary.On the mechanical side of exit strategies, there are variousphases that a trader will be in, given the time horizon and strategy he or she employs. For example, a day trader will be fightingfor every 1⁄8 while a swing trader may be less focused on fightingfor the same 1⁄8. The day trader working with greater size is alsoconcerned with finding greater liquidity at each price level,while the swing trader is inclined to allow for more price discretion and movement. In the case of a highly capitalized professional trader who will scale into a large position over days, thesame liquidity issues will arise. Therefore, regardless of the timehorizon of the trade, consideration for liquidity must be accountedfor in both trade entry and trade exit. Because of this, day tradersand traders that trade larger size need to know when to be aggressive or passive. This determination is best made based on themicromomentum of the market and the stocks they are trading.For the purpose of this discussion, I will use an exit strategy example from the long side, but the same theory applies when coveringshort positions (buying).Aggressive sellers, in this context, get the best price possiblewhile exiting trades in the most expeditious manner. Sellers wantthe best price possible; therefore, the momentum of the stocksthey are trading is most important to find the best price with themost liquidity. Selling into a rally is very effective and desirable.Conversely, if the momentum is showing signs of weakness,aggressive sellers find liquidity at or below the bid. Aggressivesellers hit the inside bids placed there by market participants oreven hit bids below the inside market when liquidity fades at theinside bid. Passive sellers will offer their stock at the offer price oreven above the inside offer as seen on Level II when upsidemomentum is present. The risk for the passive seller is that nobuyers may be willing to lift their offer, causing the passive sellerto remain in the trade. If a stock saturates at this price level, thisrisk is realized, causing many passive sellers to become aggressive sellers, hitting bids at or below the inside market. The swingin price from a passive seller to an aggressive seller can be
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extreme, such as a 1⁄2 point or more, which amounts to seriouscapital when trading larger size like many traders do.Often the need to shift from a passive seller when there isperceived upside bias to an aggressive seller is real becausewhen stocks truly roll over, selling motivation far exceeds buying motivation. This is when the risk of chasing stock is greatest,which can for even the experienced trader yield a very high market impact cost (MIC). The reason that even an experiencedtrader can get caught when these reversals occur is that emotionsdo kick in, and emotions are the nemesis of the trader. For example, if a stock like Juniper (JNPR) is 165 X 1651⁄4, 500 X 2000, anda trader is long 3000 shares, if JNPR finds resistance at the offerof 1651⁄4, this trader better act fast as an aggressive seller. In a scenario like this, I wouldn’t hesitate to hit the 1647⁄8 or bid evenlower depending on how strong the selloff was. Getting out of atrade quickly in a situation like this is far more comforting thanwaiting to see where things turn out. Most amateurs will notlearn this until many painful lessons are taught.The other risk associated with the seller in this scenario isthat the probability that other sellers are in the market at this saturation point is very high, hence making it more likely that theselloff will be severe. The possibilities in this example are almostendless, but the example illustrates the subtle nuances ofmomentum trading to determine aggressive or passive strategies.Once you decide how aggressively you want to sell, youmust Know how to route your order to reach your objectives.This was touched on in Chapter 2 briefly, but we will go intodeeper detail now in determining which execution system touse. Selecting the right ECN, SOES, SelectNet, or other meanswill prove invaluable considering that time will be wasted insending a futile order, which can prove to be quite expensive. Bythe time you receive your cancel alert and change routes, evengiven the speed of an EDAT system, a volatile stock can reallyhurt you.The first thing an ECN attempts to do is match new orderswith ones that it already has on its system. Its inventory ofunfilled orders is simply called its “book,” meaning book of openorders. Traders love it when they get an “instant cross,” as it iscalled. Fills can come back to you in nanoseconds when crossingorders, and knowing how to cross orders and which systems to
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use to get such a fast fill is imperative. If the ECN does not havea match in its book, it does one of two things. One type of ECNholds the order in its book and waits for a match. The Island ECN(ISLD) is the archetypal example. Just like its name, it is anisland unto itself. But it will post orders it cannot fill to Level IIor its internal book of liquidity. If the order becomes or joins thebest bid or offer (BBO), the order will display on Level II. Thelimit-order protection rule of the exchange provides for this.Otherwise, if the order is away from the BBO, the order will beplaced in the internal book of liquidity of the ECN. This way anindividual trader becomes a de facto market maker, without having to make a two-sided market in the stock. Like a market maker,the world sees your order once it is on the Level II.The second type of ECN routes orders it cannot immediatelymatch to other ECNs for a match. The Archipelago ECN (ARCA) isa prime example. Like its name, it represents a group of islands orbooks of liquidity through a “proactive” algorithm that attempts tofind a contra to fill an order. The Speer Leeds and Kellogg Redisystem (REDI) is also such an ECN.The decision traders face when selecting between these twotypes of ECNs is which one will get orders filled faster and at thebest price. With the Island ECN, unfilled orders go into its book,which is very liquid in most actively traded stocks. If the unfilled orders are near the inside market and the market is movingin the direction of the unfilled orders, they will get filled. Archipelago, on the other hand, searches for liquidity if it cannot fillan order. This takes time as it sends and resends the order toother ECNs and market makers through either a direct route orwhat is called a SelectNet preference. Where Island representsonly its own liquidity, Archipelago can find liquidity within theNASDAQ market (listed stocks are also included). Experienceteaches the electronic trader that each type of ECN can be useful.It depends on where the liquidity you are seeking is for a specificstock. In other words, either type can be your better bet depending on your strategy.The listed and regional exchanges have their own electronicrouting systems as well. The New York Stock Exchange andAmerican Stock Exchange have SuperDot, while NASDAQ hasthe famous Small Order Execution System (SOES) and SelectNetsystem.
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Another big consideration is what types of orders will thesesystems accept. For example, ARCA accepts only round lots of100 shares or multiples of 100 shares, while ISLD accepts oddlots. Let’s say you are buying 500 shares of Biogen, Inc. (BGEN),and you get a partial fill of only 425 shares from an SOES order.You could not sell the remaining 75 shares through ARCA,while ISLD would take the order. Additionally, although notrecommended as a rule, you might place a market order in anemergency, which you can do on ARCA but not on ISLD. Thesenuances must be known, and you can expect them to change.For instance, ARCA will most likely accept odd lot orders in thefuture as well as allow listed stocks to trade through it; therefore, the dynamics of the market and the tools we use must becontinually studied.
ELECTRONIC AND MENTAL STOPSIn addition to understanding the mechanics of trading systemsand how aggressive or passive to be while using them, anotherrule required of all traders is to Set mental stops, which is imperative prior to ever even entering a trade. This rule requires thatyou program your mind before programming your computer.The two methods for setting these stop levels are mental andelectronic. Mental stops are simple price levels you set in yourmind that, once met, prompt you to exit or enter the trade. Thisis the mechanism of most professional traders who monitor theirpositions closely throughout the day and don’t want to reveal tothe market where their entry and exit points are.A stop-loss price represents the worst-case scenario for getting out of trades when things do not go as planned—it represents your threshold for pain that you are unwilling to exceed.The reason for mental stops is that, as in poker, you never wantto show your hand. Think of market makers and online firms thatsell order flow to wholesaling market makers as “secret handshake” poker partners. They love to know your buying and selling intentions so that they can trade against them or provideliquidity with them. Telling a market maker where you want totrade your stock is showing your hand. Many argue “What’s the
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difference? I wanted to trade at that price anyway.” The problemis that there is little to be known about the market condition atthese literal price points where stops are set, since stops usuallyrepresent the market condition at some time in the near future. Iwould much prefer to analyze the market condition once mystock reached this price point to decide if it is to my advantage tomake the trade. Relying on stops, without being present whenthis price criterion is met that triggers the stop, to me, is like getting up from the poker table and telling your opponent to pick upa king of hearts for you while you are getting a drink. What transpires in hands while you are away will affect you dramaticallyif you still want the king of hearts, not to mention the fact thatyou told your opponent where you want to trade cards. In themarket the same is true for a day trader. I don’t want some market maker to know where I want to buy or sell stock until I showit to them as I hit their bids or lift their offers. This is why mental stops are important. I program my mind where I want to buy,such as the case with a buy stop, or where I want to sell, such asthe case with a sell stop. Obviously, limit-order protection can beadded to stop orders if stops are to be used.Electronic stops are now available on EDAT systems thatallow the trader to set these limits on his or her own PC without sending the order to a market maker or broker who maytrade against them. The local PC holds the order electronicallyand fires the order when the conditions that you set are met.This keeps the order safe and sound on your PC without anypossible manipulation. The risk with these systems, though, isthat prints away from the CMV—defined as trades that areprinted to the market that are not representing the current pricein a given stock—could trigger a stop order due to a bad print.This can occur for several reasons such as late prints or tradesbeing reported out of sequence. While the situation is relativelyinfrequent, it is a real possibility and the reason why I amapprehensive about using electronic stops.The reason stops can make sense for you when used properly is that they give you the benefit of what I call “imposed discipline.” For example, if you are going long 3 Com Corporation(COMS) because you expect a bullish move based on MerrillLynch & Co.’s upgrading it to a buy from a hold, where will youget out if that move does not materialize? You know in advance
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how much heat you are willing to take, and the electronic stopmakes sure you follow through. If COMS does not break out andinstead stalls or reverses relative to your position, you automatically have a defensive strategy programmed, and you shouldalways be defensive in your trades. Offensive when getting in,defensive when getting out! Remember, the right trades willpretty much take care of themselves; it’s the losses that requireyour most disciplined attention. Electronic stops impose that discipline on you by preprogramming the stop limits into your PC.
THE MATURATION OF HARD AND SOFT DATAWhile mechanical understanding is invaluable in terms of whichtools to use and the strategies to employ while using them, market psychology, technical indications, and experience will alsogreatly contribute to exit strategies. A cliché I introduced inChapter 3 has such widely followed acceptance that I have madeit a rule: Stocks tell their own story ahead of the news. Whilethis rule is true and applicable for entering trades as well as exiting, recognizing and reacting to key market indications to exitstocks gives a trader an edge that most new to trading don’t recognize exists. Increased market maker activity, new support orresistance levels over key moving averages, and so on are allclues that some kind of news or impact is about to occur. Thenews could be a new development in the biotech sector or anincreased consensus of professional traders or even increasedactivity of day traders, but the point is, whatever the reason,stocks tell you what is happening before the media and even analysts can generally explain it. Therefore, traders must learn toread the signs first and then to react to them with some degree ofspeculation or uncertainty to take advantage of the impendingnews as others follow suit on the discovery of the same information or media coverage (certainty). In terms of Dow’s wave theory, you are on the wave that trends one direction or the otherbefore the masses; hence, you benefit from the move and possibly avoid downside risk. By the time the news is well known,you will know whether to stay away from the trade or go theother way. Either way, chaos is generally the result once the pub-
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lic and the media get a hold of some market-moving news, andchaos is difficult to trade regardless of your experience level andtime horizon.In fact, discipline is not defined by controlling downsiderisk through cutting losses in terms of literal prices but by recognizing indications that illustrate that weakness is setting in andthen acting on the information by liquidating (long positions) orcovering (short positions) prior to the associated price change.Price is again a lagging indication. The events that can be seenprior to the associated price change can cause you to be a moreproactive trader, which is incredibly important for active trading.The ability to adhere to your strategy, and the rules associated with it, is really what defines discipline, not literally cuttingevery loss at a 1⁄16 or 1⁄8 for day trades or 1⁄2- or 3⁄4-point downturns forswing or longer time horizon strategies. The key is to know whatindications correctly identify imbalances in supply and demandas well as volume and to monitor when such indications presentclues as to when to exit the trade. The discipline to act on theinformation will automatically reward the proper behavior.Think of this philosophy as the “invisible hand theory.” Inmacroeconomics Adam Smith used this term to describe the natural force that guides capitalistic free markets. In trading, theterm could be adapted to describe the natural force that if theright activity is employed and the discipline to follow the rulesassociated with the strategy are followed, the positive resultswill be delivered as if an invisible hand gave you the results youdesired.
TAKING PROFITSAs indicated at the beginning of this chapter, a fine line existsbetween selling profitable positions too soon and hanging on toolong. As a rule, Don’t expect to squeeze all the juice from theorange. This simply means that the trader who can be satisfiedwith a lower net return by taking less profit will reduce his or herrisk for the exchange of acting early and exiting, while themasses provide the liquidity needed to exit the trade. Moretraders lose in short-term trades, day and swing trades, by stay-
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ing in trades too long. If you get out of a trade with a profit andthe trade continues to run in what would have been your favor,do not look back in regret. For example, you visualized a trademaking a 1-dollar move. It did that, and you exited the trade,only to watch it move up another dollar.Did you leave a dollar on the table? No! That is 20/20 hindsight and not good mind food. While we want to let our profitsrun based on the indicators we follow, we cannot punish ourselves for not selling the tops or buying the bottoms. That is notthe essence of trading. Trading is about taking consistent highprobability trades often, and moving to the next trade, even if inthe same stock. This is not a cause for self-recrimination. It is atime to enjoy a dollar-per-share profit.Exit on reaction, not price. This rule becomes even moreimportant to traders who trade size. Traders who move 20,000shares at a time, for example, need more outlets and liquidity tostay nimble. For example, when trading into a trend, I wouldprefer to trade within the middle 50 to 60 percent range of amove. (See Figure 6.1.) The lower-risk zone exists within thismiddle range, while providing higher consistency, as opposed totrading the edges of a trend at support and resistance where therisk of reversal is much higher. If I am trading trend reversals,and fading the beginning of the end of a trend, whether up ordown, then I want to buy near the support level and sell near theresistance. (See Figure 6.2.) Those that think they must top tickthe trade when selling and bottom tick when buying miss thepoint and are at a distinct disadvantage since they increase theirrisk dramatically while being “whipsawed” out of trades themost as they realize they cannot pick tops and bottoms.
THE MARKET IS UNFAIRThe basis of this rule, The market is unfair at times, requires youto remember that mechanical understanding is somewhat easy; itjust takes time to study and practice the theory. Mechanicalunderstanding in the grand scheme of things is in my opinion nomore than 10 percent of trading. But the psychology of understanding how to use the indicators to open and close trades aswell as developing the discipline to follow such indicators is
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FIGURE 6.1 Trading into a trend
FIGURE 6.2 Trading trend reversals
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what really separates professionals from amateurs. The psychology of trading is a journey that continually evolves, and thatmakes up the other 90 percent. Exiting trades is tougher for mostnot only because timing is so critical but also because emotionsseem to run the highest when exiting a losing trade. Every rationale will enter your mind trying to convince you to stay with thetrade on the belief that the stock will come back. Think of thatvoice in your mind as the little devil on your left shoulder, tellingyou it will be OK. Doing the right thing may not seem easy at first,but once you form the habit of cutting losses quickly, it becomesquite routine and very gratifying. Taking the devil’s advice willprove very damaging very fast, but in time you will not hear fromhim anymore because you won’t be trading! It is very easy foreven experienced traders to exit too early on profits and too lateon losses. Of the two, early with a small profit is far better thatlate with a loss. On the other hand, no trader wants to leave goodmoney on the table or get whipsawed. The latter occurs when youenter a trade, and it moves against you. You exit only to watch thestock move in what would have been your way had you notexited the trade. You were head-faked out of a winner.If you beat yourself up about exiting too early, you set yourself up to exit future trades too late. That is the risk. Worst of all,the world’s greatest traders cannot time the market with impunity. So accept this fact of the market and incorporate the rightbehavior so that when it occurs, it is the exception, not the rule.The market may seem unfair at times, but never lose your statistical advantage by letting that destroy your discipline.
CHANGE YOUR PERSPECTIVEWhen swing trading, I will often use that time to study my tradefrom other perspectives. I will ask myself what I would do if Iwere in a day trade or even if I were longer-term oriented. I perform this function by studying the charts when other signals arenot totally clear to me. I ask myself questions like the following:• What are the profit takers and contra (shorts) side tradersseeing?
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• Why would someone take profits or short your stock atthis price?Price charts of the stock being traded from different perspectives provide useful indications that, while they will not give methe clarity I am looking for, will expand my perspective in termsof time horizon. Let’s say you are looking at a one-minute intraday chart. What does it look like set at 5-minute intervals? Orwhat about a weekly view? Or monthly, quarterly, or 200-daycharts? Run some technical studies at these different time intervals. Every once in a while, take a look at how other traders seethe same market you are trading. From someone else’s perspective, you might see different trend lines or major support andresistance levels that explain why they are trading against you. Atthis point, as always, you evaluate the supply and demand issuesbut from a longer time perspective. These questions will never betotally answered, but they do present perspectives that will influence your bias, especially when used with other indicators toform an overall opinion. When that bias is against your positionand you no longer feel the stock is acting well relative to it, this isa good exit indication. You certainly want to use hard data andindicators to support this bias, but in the end, your feel (soft data)generated by experience and multiple time perspectives will helplead the way. If clarity is still elusive, follow this closing rule:When in doubt, get out.
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ome market participants traditionally defined as professionals, such as market makers, specialists, institutions,and active traders, have created a paradigm of trading thatis narrowly focused on just one financial vehicle. But with theaccessibility to the market available today, traders must incorporate a multidimensional approach to provide an opportunity toreduce risk and hedge equity positions while allowing profits tocontinue to run.One of the most powerful ancillary and complementaryfinancial vehicles to understand and marry to equity trading isan options contract. While options trading has gained tremendous popularity since the inception of organized and standardized options markets in 1973, many engage this market segmentfor the wrong reasons and with the wrong strategy. Whileoptions can be a great speculation vehicle and they should beincorporated as a strategy in time, hedging risk with options isa more important topic to begin with. This chapter will focuson strategies that will help the electronic swing trader hedgerisk through options contracts as a complementary strategy totrading stocks. The rule is simply Understand options contracts to hedge risk and produce income. There will not bemany rules in this chapter regarding options; instead, I willfocus on strategies that will enhance your trading dramaticallyas you evolve into a more sophisticated trader.I will not focus on all the mechanics of options basics in thischapter since I assume that you either already have an understanding of options or will acquire it. I recommend two books asresources that provide an excellent opportunity to get startedtoward this knowledge and reinforce options basics. The firstbook, All About Options, was written by my friend, ThomasMcCafferty. The second book I suggest reading is McMillan onOptions, by Lawrence G. McMillan. Both books are strong introductions to options trading. Although these books are unevenly120
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biased to options trading and cover very