The Market Maker's Edge: Day Trading Tactics from a Wall Street Insider [NOOK Book]

First Chapter

MANAGING MONEY TO SUCCEED AS A DAY TRADER

After graduating from college, Avi Levichuk was eager to make big cash by
day trading. He heard many stories about SOES bandits making thousands of
dollars a day flipping in and out of stocks. Avi believed that all he needed
to do was catch a couple of waves a day trading Internet stocks. If he did
this, he would make anywhere from five to ten points, or five to ten
thousand dollars, per day using 1,000-share lots.

Avi went to a SOES shop on Broad Street and plunked down his bar mitzvah
money, $25,000, plus another $25,000 he borrowed from his grandfather. With
the $50,000 he would qualify for 4 to 1 intraday leverage, providing him
with $200,000 of buying power. He estimated this would be enough to allow
him to trade high-priced Internet stocks such as Yahoo, Ebay, or Amazon.
On his first day of trading, Avi was briefly up $4,000 on a 1,000-share
position in Ebay. Then the stock turned against him and he was quickly down
$3,000-a $7,000 reversal. Instead of cutting his losses, Avi bought another
1,000 shares, in order to "average down." Ebay sold off another 6 points and
suddenly Avi was down $15,000, or 30 percent of his $50,000, in less than
two hours. Unable to take the pain anymore, Avi sold his 2,000 shares-at the
bottom of the move. Within three weeks Avi had lost all of his $50,000
dollars, and on top of that he owed the firm $3,000. If he had understood
the principles of risk control, his chances for success would have increased
dramatically.

Risk control is the foundation of survival for all traders. It is one of the
few aspects of the marketplace that a trader has control over. The most
common error made by beginning traders is a disregard for risk control by
taking overly large positions. Unreasonable expectations can cause beginners
to gamble 50 to 100 percent of their portfolios on a single trade. Taking
wild shots with huge positions is not trading-it's gambling. Successful
trading is developed over time, by winning consistently and conserving
capital.
Trading positions that are too large often results in huge losses; it is the
most common reason beginning traders go broke quickly. Large positions go
hand in hand with large emotions: The bigger the position, the more intense
the feeling of either greed or fear. The large P&L swings associated with
big positions usually cause traders who are just beginning to abandon
discipline and to trade subjectively and emotionally. On one hand, it is
harder for them to take the loss because of its size; on the other hand, it
is harder to let the profits run on a position that's too big. Traders end
up cutting their profits short and letting their losses run-the opposite of
what they should be doing in order to be successful.

TRADE ONLY WITH MONEY YOU CAN AFFORD TO LOSE
Sun Tzu said that "Every battle is decided before it is ever fought." He
meant that through meticulous planning and preparation before a conflict, a
person should be able to get into a position such that victory is assured.
When the battle occurs, it will take place against an opponent that is
already defeated-a result of the prior planning.* The same methodology
should be applied to trading. Before trading, traders should put themselves
into a position such that the victory can be assured by substantially
reducing the meaning of their losses.

The emotional pitfalls of trading are magnified exponentially when you have
to trade successfully in order to survive. The most successful traders have
an almost complete disregard for money. The need to make money forces a
person to be attached to the outcome. This attachment normally influences
the decision-making process for the worse, because fear is magnified,
distorting reality.

Traders must be comfortable with the worst-case scenario before they even
consider the best. The most successful traders have become comfortable with
the idea that they can lose it all; paradoxically, that idea provides them
with a sense of security.
Only you can determine how much money you can afford to lose. The money you
trade with should be money that you are comfortable with never seeing again.
If you decide to invest in a career as a day trader, ponder this question
carefully.

SMALLER IS LARGER
The importance of financial management when applied to position size cannot
be overemphasized. Wall Street is filled with stories about experienced
traders who went broke after long and successful careers because they
ignored the oldest and most important rule of money management: Don't take
positions that are too big for your financial comfort level.

The urge to make money quickly will always tug at you when you're trading.
Fight this urge so you don't have to learn a painful lesson the hard way.
Successful trading is first and foremost about survival through financial
preservation and consistency, not about hitting home-run trades with huge
positions. It takes strict discipline and careful preparation to match your
positions to your risk profile. The smaller your positions, the easier it
will be to maneuver in and out of trades, whether you are adding to a
winner, cutting a loss, or taking a profit.

There is a direct correlation between correct position size and higher
profitability. Losses are inevitable; but smaller positions produce smaller
losses, allowing quicker recovery and less emotional attachment. The key
here is emotional attachment. Traders tend to develop a comfort zone for
position size, given their financial capacity to take risk. If you trade a
position that is too big, then your sense of detachment can be thrown out of
whack, adversely effecting your ability to maintain objective discipline.
What causes a trader whose comfort zone is 2,500 shares to buy 10,000
shares? Traders take positions that are too large for a variety of reasons:
greed, lack of understanding of money management techniques, faulty trading
tactics, the ever-present ego, and unrealistic expectations.

Larger losses are the product of bigger positions. A big loss requires a
higher gain in the future to offset it, because of slippage, time, and
commissions.

It is much harder for a trader to trade out of a large hole than out of a
smaller one. If a trader is down around 6 percent on the month, chances are
that the trader's confidence and buying power will remain intact. Successful
traders are not afraid of reasonable losses, because they have confidence
that they will persevere to make back what they lost and more.

However, if a trader is down 50 percent on the month, it will be a lot
harder to regain confidence and stability. Large losses sting, and can cause
a trader to be gun-shy in the future.

It becomes increasingly difficult to recapture an unusually large loss when
you trade position sizes that are not evenly distributed. In addition to
making back the equivalent percentage lost on the bigger position, you'll
have to make back the spread and commissions. Many traders who experience a
skewed loss resulting from a position that was too big believe that the only
way they can make it back is to take a large position again. When this
occurs, a trader is operating at a psychological disadvantage arising out of
desperation. The result is that the risk profile is endangered, and the
trader loses the best source of protection.

TRADE WITH BALANCED POSITION SIZE
Position size in trading should be adjusted for broadly uneven stock price
levels. Uneven stock price levels result in uneven probabilities that a
large percentage move will occur. If you hold both a $10 stock and a $100
stock, a one-point price change in each one will have an equal impact on the
profit or loss of your portfolio if the position sizes are equal. However, a
one-point move in each stock would represent very different percentage
changes. A one-point move in the $10 stock represents a 10 percent price
move; a one-point move in the $100 stock represents a 1 percent price move.
The 1 percent price move in a stock is statistically less significant, and
thus more likely to occur, than a 10 percent move. Therefore, it does not
make sense for traders to take equal position sizes in stocks that have
broad price discrepancies, although they do it all the time.

A $100 stock would have to move 10 points in order to yield an equivalent
percentage change to a 1-point move in a $10 stock. The 10-point move would
have 10 times the dollar impact on a portfolio if the position sizes were
the same, an unbalanced risk allocation. Position sizes should be adjusted
according to the price and number of stocks you are trading, such that an
equal percentage price change will have an equal profit or loss impact on
the portfolio.*

THE 2 PERCENT RULE
One of the principles of risk management is the 2 percent rule. The rule
states that no more than 2 percent of a total portfolio should be lost on
any individual trade. Ideally this figure should include the costs of
commissions and slippage. This means that the largest loss you should
tolerate on any single trade is 2 percent of your portfolio. Some people
misinterpret this rule to mean that only 2 percent of your trading equity
should be allocated to each trade, but that's not the case. The 2 percent
rule is designed to limit a trader's losses while preserving capital. It is
powerful insurance because it provides a trader with a number; you know
before you enter a trade how much you can afford to lose. Applying this
principle, a trader can afford to be wrong numerous times and still live to
see the next trading day.

Keeping your losses to 2 percent per trade often means that you will have to
trade smaller positions. Many traders who are just starting scoff at the
idea, thinking that bigger positions will allow them to strike it big and
make a large monthly income through big profits. Nothing could be further
from the truth. When beginning traders take on bigger positions, it often
causes them to lose money faster because they have not built up the
tolerance for accepting larger losses or bigger profits. They tend to take
profits off the table faster when they are winning, because of the immediate
gratification associated with being right. They also tend to let their
losers run longer, because they are not willing to accept the pain
associated with being wrong.

It is not uncommon for traders to enter into positions not knowing
beforehand how much they are willing to lose, because they think they are
going to win. When expectations for a trade are not met and no exit strategy
exists, a trader is often forced to cut a position based on either emotion
or financial pain. The goal of a trader should be to accept losses without
letting them affect his confidence. This is accomplished through preparation
before the trade, budgeting for losses just as you budget for an insurance
bill.
The 2 percent rule is pivotal because the success of an individual is not
necessarily correlated to the number of winning trades: Some of the most
successful traders on Wall Street earn up to 80 percent of their profits
from just 20 percent of their trades. This means that the majority of their
trades may not earn them the big money. The reason they are profitable as a
trader is that they have learned to quickly accept and manage loss, not
disregard or try to eliminate it. Successful traders aim to keep loss
controlled. When losses are controlled a trader is free to focus on and add
to winning trades.

By limiting individual losses to 2 percent or less of your portfolio, you
increase the odds that you will experience more break-even and winning
trades. Over time, these trades tip the scales toward profitability, as long
as losses are managed. The 2 percent rule is particularly beneficial for
beginning traders. Your probabilities of success increase with the number of
times you play. A 2 percent maximum loss guideline increases the life span
of beginning traders, providing them with the opportunity to learn from
their mistakes.
A loss of 6 percent to 8 percent is the maximum a trader should accept for
the entire month. A trader who has four consecutive 2 percent losses should
stop trading for the month and evaluate what's going wrong. You can always
begin anew the following month. Taking time off after a string of losses is
beneficial, because it provides you with an opportunity to regain your
confidence. A trading time-out is similar to a basketball time-out after the
opposing team has scored a number of unanswered points. The time-out slows
the winning team's momentum and helps the losing team regain confidence with
a pep talk and a breather. If you enter a trading day lacking confidence,
close the shop and begin again tomorrow. Confidence in yourself and what you
are doing is your strongest ally.

MARGIN MADNESS
Using margin to increase buying power is an accepted and common practice
among most day traders today. It is important for day traders to be aware of
the risks of margin, and to learn how to handle the augmented buying power
effectively if they choose to use it. Using excessive leverage through
margin is a dangerous game. The sell-off in Internet stocks in the spring
and summer of 1999 resulted in a huge number of margin calls for day traders
and investors. The risks associated with margin require careful planning and
tighter stop-loss criteria. Many investors are not aware of the risk
inherent in using leverage, and should stay away from it. When the market
turns against a highly leveraged position, a trader is often forced to
liquidate it at the worst possible moment.
Even the brightest and most highly regarded traders on Wall Street are not
immune to the danger of trading with excessive margin.

During the predicament in the global financial markets in September 1997,
the Long Term Capital Management (LTCM) hedge fund reported that it had lost
$2.3 billion in high-risk trades and was on the verge of bankruptcy. Fund
founder John Meriwether and his partners, Nobel laureates Myron Scholes and
Robert Merton, traded with ridiculously high levels of margin. At times they
took huge positions, putting only 5 percent down. Although they attempted to
diversify the risk with long and short spreads in their bond funds, the
bloated margin ultimately proved fatal. The amount of margin power that LTCM
used is the equivalent of a stock trader buying $100,000 worth of stock with
only $5,000 cash down. A small hiccup in price could easily wipe a trader
out with such high degrees of leverage.

In a report issued on August 9, 1999, the North American Securities
Administrators Association stated that it is not uncommon for some day
trading firms to encourage day traders to borrow money from other traders in
order to meet margin calls. This practice flies in the face of the most
basic risk management practices and should be avoided at all costs. It is a
clear sign that the trader is acting out of financial desperation and that
the end is near.

When you choose to trade on margin, enforce strict risk-control standards
geared to the amount of underlying cash you have to trade with. If you have
$50,000 to trade with and you are using leverage through margin, your risk
standards should be focused around the $50,000 in underlying cash, not the
amount of buying power you are using. Applying the 2 percent rule, your
maximum permissible loss will be $1,000 per position.

Success in day trading is first defined as survival. Your ability to survive
as a day trader depends on your money management techniques. When you manage
your money properly, you provide yourself with valuable risk insurance,
which any business should have. The best way to control risk when trading is
to manage your losses. Determine the most that you are willing to lose on
any one position, which should not exceed 2 percent of your underlying
equity.

Keeping your individual losses to 2 percent or less often requires that you
trade smaller positions to start. Smaller positions can be empowering
because they allow you to trade with less attachment, permitting you to cut
your losses sooner and easier. The key to success in trading is to have the
least possible emotional attachment to your positions. If you are trading
because you have to win, chances are that your attachment to the outcome
will be high, adversely affecting your decision-making process. When you
trade only with money that you can afford to lose, your attachment will be
minimal and your results will be better.

Risk control is a crucial component to successful trading. Improper risk
standards result in trades that can easily wipe out even the most
experienced traders. Traders last in the business because they have learned
to manage their expectations and control their exposure. When addressing the
risk factor, remember the importance of position size. Never allow yourself
to trade a bigger position than you can afford. The temptation will always
be there, but managing this urge through discipline is the mark of a
successful trader. It is always better to start out small and add to your
position, rather than starting out large and regretting it afterward.
Remember the old saying: Discipline weighs ounces while regret weighs tons.