stock. Put simply, the public isbuying what the professionals have to sell. The opposite istrue when stocks are weak. Professional sellers will sellstocks aggressively and push prices lower. Professionalsknow that what may appear to be a low price at any givenmoment will be perceived as a high price once the stockcontinues to sell off. Think of it this way: When today’s lowsbecome tomorrow’s highs, you will be glad you traded withthe professional sellers by exiting sooner rather than later.Hence, professional buyers and sellers stay together, whileamateurs rarely run with any herd. They are aimlessly roaming the Serengeti, not even knowing that they are marketprey.Q: How does this view of the market translate into electronictrading?A: I look for signals that indicate when professional buyers andsellers are entering or exiting the market. These signals comein the form of increased daily volume, sector leaders, theadvance decline line, the bond market, the oil market, andother market indicators. Many believe that a specialist is completely micro-oriented in that all we pay attention to is thestock we make markets in, but this is a complete myth. Themarket indicators I mentioned are critical tools we use toanticipate market trend. While we do enjoy the benefit of seeing order flow, we are limited to trading in issues that may ormay not be market leaders in terms of activity. Electronic trading allows me to trade whatever I want, whenever I want. As aspecialist I am committed to trading only the stocks I specialize in. As an electronic trader, I monitor sector rotation andsector strength, as I did when I was a specialist, but I can shiftmy trading attention to the stocks with the most opportunity.I did not have that opportunity as a specialist. While I believethat specializing on just a few issues is important for the electronic trader, having the ability to shift to different sectors and
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stocks as money flow shifts is a great advantage. Therefore, myview of the overall market as a specialist, while important tomonitor, didn’t always translate into opportunity in the stockI made markets in. Electronic trading has opened the entiremarket to me; therefore, paying attention to broad market indicators is even more valuable to me.Q: Where do you see the specialist system in the future?A: In my opinion, the human intervention the specialist provides will always be needed. When severe supply anddemand imbalances occur, chaos sets in. The specialist isthere to provide order and liquidity, and I believe there willbe a need for this intervention as long as market volatilityexists. So I do not see the specialist system going away, but Ido see it changing.Q: In what way?A: I believe the playing field will be leveled by allowing thepublic to participate at an even deeper level than we seetoday, such as having the ability to monitor the specialistbook. Today, the specialist book is not open to the public;therefore, transparency to the market is still very limited inthis respect. Even the regional stock exchanges, such as theBoston, Cincinnati, Philadelphia, Pacific, do not have accessto the specialist book on the New York. While they are members of systems, such as the Intermarket Trading System(ITS), that allow them to trade with the NYSE, they are limited in seeing the depth of the market in terms of buyers andsellers. I feel that in the very near future the public will havethis ability, which, in turn, will only add efficiency to thelisted market.Q: What advice would you give to electronic traders in terms ofwhere to focus and how to develop their skills?A: I would remind them that on the floor, we do not have theluxury of taking the time to do in-depth analysis. Once theopening bells sounds, we operate on supply and demandimbalances, sector strength, money flow, and attention toindicie leaders, as I mentioned before. Therefore, we have
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been conditioned through the very nature of the NYSE toreact to these signals and not to try and predict the future toofar in advance. I am convinced that nobody can do that. Sothis is where the focus must remain. Follow the sector leaders and the stocks that lead their respective sectors. Knowwhere the bonds are trading, oil, technology, retail, and so on,and let the market show you the way. I think most amateursmake trades and then hope for a bounce when they go againstthem, instead of cutting the loss and turning the other way.Because of the new order-handling rules set by the SEC in1997, all customer orders must be filled or displayed; therefore, the ability to get out of a losing trade in a liquid stockquickly makes the argument clear why holding on to a loseris not because of technology limitations or because of therules. It has the most to do with people’s psychology of lossesand the fact that they have little practice developing thisneeded skill. Most new traders today come from a mutualfund background at best. That investment vehicle teachesnothing about cutting losses; in fact, that job is left to someone else, the fund manager. Therefore, this is where I feelpeople need to focus and develop once engaged in a trade. Infact, when teaching new traders, I force them to trade out ofstocks early just to get into the habit of taking losses andreacting fast. Being “whipsawed” is not a concern to mewhen I am teaching people to trade. I want them to becomeemotionless and indifferent to profit and loss, and insteadfocus on market direction. You rarely lose money when youare on the right side of the market.Q: Isn’t that obvious?A: No, believe it or not, it isn’t. When a stock is strong with themarket or indicie it trades in, it is easy to short into a rallyand buy it back on a light pullback and make money. Theproblem is, a trader who is shorting into an up trend maymake money on any number of trades on these light volumeand shallow pullbacks, but any money made on these tradesin this example will be given back with greater losses when astocks “rips” $5 or $6 into a short position. The trend in thisexample is strong, and the trader is 100 percent on the wrongside by being short. Because these “rips” occur so fast on light
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volume, a trader can be several points under water inmoments. If you look at a chart, strong stocks on rally dayshave few pullbacks, and the pullbacks are shallow. It is betterto buy the dips to open the trade than to buy the dips andclose it. This is an example where a trader can make moneyfighting the trend, but he or she elevates the risk dramatically.This is what is meant by being on the wrong side of the market. Buying weakness and selling strength on strong days isfar more profitable than selling strength and buying weaknessto cover shorts, as a rule. The exception to this is to over sellwhen liquidating longs to get short, and overbuying whencovering shorts to get long. This is a more advanced strategythat is very effective once experienced.Jack’s insights are invaluable. In fact, the real value of themcan only be appreciated fully once you have gained some experience. Oftentimes, to truly appreciate the lessons of professionals,you must first experience the pain of your mistakes as an amateur. This helps explain why there is no better teacher than making actual trades. The premise of engaging the market whilelearning and cutting losses fast allows for experience and survival while the lessons are given one trade at a time. It is laterthat the insights of professionals will have their greatest meaning. The deepest level of learning occurs when you can look backon your own mistakes and learn from them while a professionalis helping you understand why you made the mistake in the firstplace. That’s called insight, and I could not help but think aboutmany situations in which I had done the exact same thing Jackwas describing in the last example. We all continue to learn fromeach other, even if the lesson is a lesson we have learned before.This is perhaps why high-level traders love to associate witheach other. They are constantly feeding each other with newinsights or reminders of things they already knew but were gladto have been reminded of.The trader who possesses the psychological makeup to stayinterested and to continually learn and execute new methodologies and mechanical techniques is the trader who wins. The finalinterview is with a friend of both mine and Jack’s who possessesall the attributes I have described.
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The final interview with Bill Lupien continues to build onsome of the mechanical knowledge you need to trade listedstocks and also focuses on personal psychology.
BILL LUPIENBill has spent 17 years as a specialist on the Pacific StockExchange, 5 years as chairman and CEO of Instinet, and 5 yearsas chairman of his own market-making firm. Since 1994, Bill hasalso been chairman of OptiMark Technologies, one of the newesttechnologies that I spoke about in the book. As impressive asBill’s background is, what is even more impressive is watchingthe man trade. I have had the pleasure to trade side by side withBill many times, and I can tell you the experience has enhancedmy trading considerably. You can never know too much or havebeen in the market too long to learn something; Bill has taughtme plenty.The wealth of knowledge a trader has is like a well of knowledge that can be tapped in an instant to formulate new ideas andstrategies based on situations that may not have been encountered before. The ability to use one’s intellectual resources on amoment’s notice to decipher trading opportunities is the essenceof floor trading and day trading. The greater the resources in thewell, the more opportunity one can discover. What impresses methe most about Bill is his ability to see things that most would not;he can do so because his well of knowledge and experience isdeep and full.Q: You have many years’ experience on the floor. Could youexplain how you use that depth of information and knowledge to trade electronically today?A: I think the opportunity is simply incredible that the averageperson today can trade on a level playing field with professionals. I will even say that the average person has an advantage over the market maker and specialist since there are norestrictions on the individual trader. The only barrier topiercing this veil is that individual traders do not see them-
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selves, in general, as professionals, whereas, floor traders do.Floor traders have an imposed perception to act and acquirethe skills of a professional. Most people see themselves ascarpenters, accountants, attorneys, teachers, businesspeople,and so on, with an interest in trading, as opposed to traderswho makes their living trading stocks. Greek mythology tellsa story of Pygmalion, a Greek god who expressed so muchlove toward an inanimate statue that represented his perfectmate that the statue actually came alive to fulfill the god’sgreatest wish. The expression of love was so strong that thestatue became real, somewhat of a self-fulfilling prophecy.The metaphor can be used today to explain the high level ofexpectation traders must have of themselves. It is calledappropriately, the “Pygmalion effect.” The metaphor is basedon the premise that the expression one has toward somethingmust be so strong that it creates a reality in the eyes of the participant. I believe most individuals are missing this level ofexpectation due to peripheral demands that tug on theirattention such as their careers. This deep expression for success is usually present for floor traders because trading istheir career, and most of their thinking regarding excelling intheir respective field is aimed toward the result of successfultrading. This desire runs consciously and subconsciouslythrough the minds of traders and is an intangible element thatcreates a very tangible edge. So before answering the question, I believe this level of expectation of oneself must exist tocompete with professionals who knowingly or unknowinglyhave it.Q: That is a strong insight, Bill, and it could have been formedonly through many years of training and developing traders,which I know you have done, both on the floor of the PacificStock Exchange and as the chairman of Instinet. Nowassuming an individual has that level of expectation, thepassion, what insight could you offer to the electronic traderof today based on your experience?A: There are so many subtle indications that exist in the marketthat the public is not generally aware of. While they are notcomplicated, they are also seldom disclosed to the public.
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Here is one example. The NASDAQ market is fragmented, asyou know. This means that when this market opens, tradeexecutions occur all over the board between the multiplemarket makers and ECNs. This means there really isn’t a consolidated opening for a stock on the NASDAQ market. Thisbegins to explain why so much chaos is often present withNASDAQ issues, especially on the open. With listed stocks,this is not the case.My years on the floor can be directly applied to an electronic environment in many ways. Here is one example.Because one specialist is controlling any given stock on thelisted exchange and regionals across the country, the openingprice of a listed stock is a consolidated open. This meanswhen a listed stock opens, it opens fairly and indiscriminately. Therefore, if a listed stock is indicating an openingrange in terms of price before the actual opening, electronictraders can place strategic limit orders through electronic systems like SuperDot for the New York, or Scorex for thePacific, without being subject to the inequities often associated with the fragmented NASDAQ negotiated market bycomparison to a fairer auction market for listed securities. Soif the indication for HWP is bid 35 to 37 offered, few tradersrealize that before the open, traders can enter a limit orderthat can protect them through the nature of limit-order protection while still leaving the upside should the stock openhigher then their limit price. Therefore, if a sell limit order isentered to sell 2000 HWP at 36, and the specialist opens HWPat 37, the electronic trader will be filled at 37 due to the consolidated opening. The downside protection exists if thestock opens at 35 because the trade will not be executed sincethe opening price is below where the seller is willing to trade,but the upside is not limited if the stock opens higher at 37.This is one of many examples of how an understanding of thelisted market can benefit the electronic trader. Because thistype of information is not commonly known, most daytraders today focus only on NASDAQ issues, and I believethis is a mistake. Just as traders must trade the long and shortside of the market, electronic traders must understand how totrade both listed and OTC markets.
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Q: Bill, that is very good information. What other thoughtscould you add that could be applied to electronic trading?A: I believe there still exists a form of arbitrage in the equity market beyond the obvious futures market in terms of market timing. I don’t mean arbitrage in the sense of money flow fromone market to another or execution inefficiency from oneexchange to another. What I am referring to is more related toan indication. Although what I am about to share is not a truearbitrage, the indication works from the same premise. Here iswhat I mean. Because the NASDAQ market opens at 9:30 a.m.EST (not considering premarket trading), we get to see wheresectors are strong and weak prior to many listed stocks’ opening. This creates a great indication of where a listed stock willopen. If, for example, the Internet index is getting hit in theNASDAQ market, although there are not many listed stocks inthe Internet sector, there are stocks represented on the listedexchange directly and indirectly related to this market segment that are likely to follow the trend set by the NASDAQmarket. This can be a great indication of how you will tradethe open for listed stocks once they open.Q: Bill, how much of what influences a trader is psychological?A: I think almost all of it once the mechanics are learned andlearned properly. The problem is, most people do not trulyunderstand the mechanics of the market well enough. Mostare in too much of a hurry to begin, which is a psychologicalissue itself, by not taking the time to learn to trade properly. Ihave trained many people to trade over the years, and I havecome to the conclusion that most people can learn themechanics if they dedicate themselves, but because mostdon’t or won’t, their introduction to trading is often a poorexperience, which can forever jade their psychological perspective, leaving them short on both sides in terms of marketmechanics and psychological perspective. I don’t know howanyone could survive those odds.Q: Final question: How did you and how would you train people so that they don’t fall victim to that fate?A: For the most part, they have to decide if they are willing todedicate themselves; otherwise two people waste their time.
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If people really want to learn, I would have them take at leastthree months to study the market, if not longer. If they canpass the truth test during this period, then I would have themby my side learning by doing and watching. It doesn’t takelong to tell if the psychological elements are present afterthat. I have interviewed many traders in the market, andthrough that experience, I have come to realize that this ruleis critical: If you have the opportunity to get inside the headof a true professional for even a few hours, do it!The consensus among traders is that most of trading isweighted on the psychological aspects of trading. Who knowswhat the literal numbers are. In fact, I am sure it varies by individual, yet as stated numerous times throughout the book, mostpeople are in search for that magic software system that willyield windfall profits. By this time, and at the risk of beingredundant, I hope that you subscribe to this fact so that you canfocus on the discipline and psychology of speculation in themarket. The question you may ask is, “Why is it the mostneglected subject regarding the market?” The answer is twofold.First, countless books on technical analysis, fundamentals, andmarket theory have and will continue to be written, teachingmechanical techniques, which is much easier because they aredefinable. Second, quantifiable, measurable techniques and formulas are what most novice traders want. Unfortunately, thosewho look for certainties in the market have far to search and little to find. Psychology is the one part of trading you must teachyourself. The Harvard Business Review conducted a studyregarding leadership qualities for businesspeople. The studyshowed the balance of power between cognitive intelligence andemotional intelligence. Emotional intelligence won out byalmost 5 to 1 in terms of importance. If you choose to believethese studies and opinions, you can then begin to build yourselfinto the trader you want to be. But it is important to recognizethat cognitive intelligence without emotional intelligence isprone to be overanalytical, while emotional intelligence withoutcognitive intelligence is prone to be vulnerable to swings in themarket and gambling. Therefore, the synergy that is generated byutilizing both sides of the mind (right and left brain) creates theright formula.
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How do you gain this cognitive and emotional edge? Read,study, take risk, and engage the market. Write down what youlearn, and talk to other passionate people who love the market.While they are not the majority, they are still abundant.
COMMITMENTAt this point you are probably asking, “How long does it take tolearn to trade?” Again, without being too literal, it is my experience that it takes a minimum of 1000 trades to become a proficient day trader. Certainly, results vary per individual, but thisnumber represents a good estimate. Remember, time is not thebarometer; experience is. Obtaining that experience in a shorterperiod of time accelerates the learning process. The style youchoose will determine how active and how quickly you can scalethe learning curve.Are you prepared to take the time, expend the energy, andabsorb the losses that will surely occur? From watching andworking with traders, I know very few become successful in theirfirst quarter of trading, if you define success monetarily. If youview the learning experience itself as a degree of success (as mostgood traders do) regardless of the financial implication (withinreason), this attribute of good attitude is a good leading indicatorof overall trading success. If these sound like the words of anoptimist, they are, but I don’t know many successful pessimistictraders. Once again, like life itself, optimists tend to find muchmore gratification and success than those who possess the alternative personality trait; hence this is another self-evaluation toolyou can use to determine if active trading is for you.
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Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
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hile most of the rules covered throughout the book areless likely to change, rules do in fact change; therefore,it is important not to become mesmerized by changesin the market, good or bad. That is part of the evolution of themarket. As our economy takes on new paradigms and processesorders through new media such as wireless communications, itmay leave behind many traders who will fight the change. Manyare still in search of value, or they are looking for their faithfultechnical indicators to work as they did five years ago. But weare truly in a new economy that goes beyond just the technologyrevolution. It scales into the very culture of the market and thepeople who trade it. Those of you who weather the change wellwill not only fare better financially in the short term but will farebetter in the long term as you train yourselves to embrace changeand move with it rather than fight it.The final rule I leave you with is one that, if you follow it,will continually feed positive energy through your mind. Itrelates to one of the biggest obstacles to success in life. The ruleis Live within your means. Many people will live far beyondtheir means in the belief that things have always worked out andwill continue to. This is unfair pressure to put on yourself if youare to be of healthy mind while trading. Financial pressure isprecisely a reason that you should not trade. The emotions associated with such pressure when living beyond your means jadesobjectivity and, in the end, cheats you. When money motivationis the only reason to trade, danger is not usually far behind. Thisrule can apply to life in general as well. Those that have toomuch motivation for money are more prone to cheat themselvesand even others to get the results they desire. Trading is one discipline that is far too unforgiving for “scared money” or greed.I have always subscribed to the theory that living withinone’s means leads to an enjoyable lifestyle. The good news is, assuccess grows, you can still have all the great material things you228
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desire (assuming you are normal). You can live in an expensivehome and drive a nice car, and so on, relative to your financialcondition. It is when impatience and ego set in that peopleacquire a lifestyle they cannot afford. I like the way a friend ofmine Jason puts it; he describes this self-imposed pressure as“the treadmill of life,” which constantly requires a faster andfaster pace.The best traders I know find joy beyond their materialthings. They are wholesome, down-to-earth people who have abalanced perspective on life. They are quite different from “Gordon Gecko” (who was portrayed as the greed-driven trader in themovie Wall Street), whose image was purely a media invention.If you think about it, trading successfully requires the same personal regimes that every other occupation requires. Traders willbe at their best when their stress is at its lowest levels. Manytraders will not trade when they are upset, sick, tired, or fatiguedbecause they have learned the hard way what result ensues. Simply put, they know themselves.Resting at night during those quiet moments should be atime to reflect and appreciate what you have, even if you don’thave as much as your neighbor. The fact is, you never will havemore because the next, wealthier neighbor is never far away. Ifyour paradigm is to constantly want more, you ride the treadmillof pressure forever, and that mindset will not only hurt yourtrading, but your quality of life as well. In fact, you aren’t free atall, regardless of your net worth. You will be forever fightingdemons during these quiet times that disguise themselves underthe guise of competition. True competitors compete because theylove the game; individuals who live outside their means do itbecause they have to. Again, to use the invisible-hand theory,those with the right motivations get the results they deserve, andthose with poor motivations get what they deserve as well. Thestock market has an uncanny ability to expose human motivation, for good or ill.Day traders want to be free. True freedom comes with ahealthy mindset born from living within your means. Even if youcan afford everything you own, you will never have true freedomif you can never own enough.Active trading is like taking two steps forward, one stepback when you are successful. When you are not successful, it is
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the inverse or worse. The common element in either case is thatsetbacks will occur. Those that deal with setbacks the best seemto have the financial and emotional means to engage the market.While this is disheartening to many, it is the reality. Better toaccumulate the proper capital for tomorrow and forgo tradingtoday. A poor start at trading, whether undercapitalized, or apoor outlook such as greed, leads to the same result in almost allcases, and the risk goes beyond just losing money—it also threatens your attitude. Money is much easier to replace. Once yourattitude is destroyed, it is doubtful that you will ever retrieve it,so give yourself the proper start. Be patient, and begin only whenyou have the time and resources to give it 100 percent. In themeantime if you are not ready financially, start educating yourself by reading all that you can. When the time is right, you willbe glad you made the effort.I hope that you gained some ideas from this book. That isthe goal of any trading book, to deliver a few ideas that you canincorporate into your trading style. I have at present read manybooks on the market. I have not regretted reading any of them.Some were certainly better than others, but all were worth mytime. I hope you see it the same way. We priced the book withthat belief in mind, so that you can get several books on the market for the same price that some charge for one. My belief, as Isaid throughout the book, is that you must form your own melting pot of trading ideas. Don’t expect any one book or course togive you even most of what you need. Only experience, time, anddedication to the market can provide that.Thank you for your valuable time in reading my work. Towrite a book requires the use of a two-edged sword. On one edge,I am forced to think more about how I trade to become more conscious of it in order to write. On the other edge, some critics haveargued that those that truly find success in the market are toobusy to write and are too rich to feel the need! However, the challenges notwithstanding, I have enjoyed the opportunity to sharemy ideas with others who also have passion for the market, for ithas contributed to my own trading growth and development; forthat, I thank you, the reader.Remember, true success is found through balance: a greatfamily, health, and an appreciation for taking the time for both
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defines balance. In short, have fun! I am a big believer in fun.Many market participants approach the market with such intensity that it isn’t fun. Trading should never become an unhealthyobsession. If you stay balanced, you are much more likely to reapthe rewards trading has to offer, which goes beyond just financialrewards.
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ongress has passed a series of tax laws very specific forstock traders, or as they term it, “traders in securities.” Thisappendix is not designed to provide comprehensive coverage of tax laws applicable to stock traders; rather, it is intended tomake readers aware of alternatives in tax reporting for their stocktrades. These laws are very beneficial for the trader, and wehighly recommend that the trader either become familiar withthese laws or seek professional advice from someone who is.The applicable Internal Revenue Code (IRC) benefits foractive traders are found under IRC Section 475, “Mark to MarketAccounting” (MMA). Additional information can be found inRevenue Procedure 99-17 and Revenue Ruling 97-39. Mark tomarket accounting was significantly discussed and defined inthe 1997 through 1999 tax revisions.To gain an understanding of the benefits of MMA, it is beneficial to review the basic categories of investors and traders andthe tax law applicable to each. Individuals who are active in thestock market typically fall into three categories:• Investor• Trader in securities without a qualifying MMA election• Trader in securities with a qualifying MMA election
INVESTORMost people treat trading activity on their tax returns asinvestors. An investor reports all trading activity on Form 1040,Schedule D. Trades are treated as either long or short termdepending on the holding period. Trading losses can bededucted against trading gains, plus up to $3000 per year. Excesstrading losses that are currently not deductible may be carried234
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forward to future years to offset future gains. Investors maydeduct only “realized losses” (subject to the wash sale rules);they may not deduct “unrealized losses.” Unrealized losses arelosses on open positions held at year-end.The wash sale rules state that a taxpayer may not deduct aloss on any security sold if that security is repurchased within 30days. This obviously creates problems for the active day trader,and it is an accounting nightmare as well.Deduction of investment-related expenses is limited and isreported on Schedule A. A deduction for margin interest expense is limited to investment income. Investment income islimited to dividends and interest and does not include capitalgains. Nondeductible margin interest may be carried forward tofuture years.Other investment-related expenses are also deductible onSchedule A as a miscellaneous itemized deduction and are limited to the extent that they cumulatively exceed 2 percent of ataxpayer’s adjusted gross income. Nondeductible expenses maynot be carried forward.These restrictive tax rules can cost the individual whoreports his or her trading activity as an investor would a tremendous amount of tax dollars.
TRADER IN SECURITIESInternal Revenue Code 475 created a new broader classificationof active stock trader, termed a “trader in securities” (TIS). A TISis in turn classified into two subgroups, a TIS who elects MMAand a TIS who does not elect MMA. If a TIS elects MMA, thatindividual must continue under that method of accounting for aslong as he or she is actively engaged in the business of trading insecurities.
TIS WHO DOES NOT ELECT MMAA trader in securities who does not elect MMA reports all tradingactivity on Form 1040, Schedule D. All trading activities are
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treated as capital gains and losses and are subject to the restrictive rules applicable to investors discussed above. The major difference is that the definition of “trading expenses” is expanded,and they are fully deductible on Schedule C. A TIS may qualifyfor this qualification even with long- and short-term holdings.
TIS WHO DOES ELECT MMAA trader in securities who elects MMA reports all active tradingactivity on Schedule C as ordinary income or loss. In otherwords, gain or loss from active trading activity becomes ordinaryincome in nature and loses its capital transaction classification.Losses are not limited per the investor rules discussed above. Inaddition, losses may be deducted on open positions held at theend of the year. Expenses are also deducted on Schedule C andare not limited in any way.Should the active trader report a profit during the tax year,the gains are not subject to self-employment tax.A qualifying TIS may maintain long-term investmentaccounts and report those holdings on Schedule D as long asthey are clearly held in separate accounts and are not mixed withthe trader’s active trading account. Therefore, the active TIS witha proper MMA election can still take advantage of the beneficiallong-term capital gain rates while also taking advantage of therelaxed rules for his or her active trading accounts.All TISs with MMA may currently deduct trading lossesagainst other income such as