The Trader's Reference Guide--Part 5

This article marks the final installment in our Trader’s Reference Guide series. Over the last year, we have covered a wide range of topics in relation to the active trader. From the equipment and software to message board services and real-time data vendors, our goal has been to educate you on what is available so that you can better equip yourself for this fast-paced world. As we draw the series to a close, this article will serve to refresh and condense the myriad of information presented in the preceding four articles. In addition, we will take you through a “day in the life” of an active trader—from the pre-market preparation to the closing bell, and everything in between.

Not for the Faint of Heart

We began our discussion of day trading in the March/April 1999 issue of Computerized Investing with a warning about its prospects that stands repeating—day trading is by no means a “get rich quick” endeavor. Statistics provided by the Electronic Trading Association (ETA)—a group representing many of the day trading firms in the country—show that only about one-third of those who day trade actually make money. Of the other two-thirds, half break even while the rest lose money.

If you plan to be one of those who buck the trend and succeed, however, you should be prepared to lose money for the first three to six months while you learn the ropes of day trading. Even before you make a trade, you should realistically have between $50,000 and $100,000 of risk capital with which to work. This should be money you can afford to lose. Some of the negative stigma that has been attached to day trading is due to those who trade with money they have borrowed or cannot do without—college loans, retirement money, etc. Again, if you cannot afford to lose the money, you should not be using it for day trading.

Beyond the financial costs, day trading carries with it a significant time commitment as well. Day trading is something that cannot, effectively, be done on a part-time basis during the course of a trading day. Pure day traders do it as a profession. The market, especially the popular Internet stock sector, is volatile enough where a few seconds can translate into thousands of dollars made or lost, depending on the size of the position.

Technology for Your Needs

The recent explosion in the popularity of day trading has been facilitated—to a large extent—by technology. High-speed computers, networks, and the Internet now allow for tremendous amounts of information to be transmitted almost instantaneously—a must for day traders. As a consumer in today’s wired world, it is beneficial to stay on top of these advances and take advantage of them. If you currently own a computer purchased within the last couple of years, you should be positioned to utilize most of the computing technology on the market today. If your system is older than that, you seriously need to consider whether you would be better off upgrading to a more advanced system.

Before you go out and purchase your new computer, it is imperative to answer several questions. This will ensure that you have the computing power and capabilities to perform the tasks you are interested in doing. These questions revolve around the operating system (Windows or Mac), the amount of computing power (processor speed and memory), storage system (removable drives, tape backup), modem, and display capabilities (monitor size, multiple monitors). The answers will come as you decide what you want to do with your computer. The type of investment analysis you will be doing will dictate the software you will need, the amount of data (and storage) required, the type of Internet connection you need, and other decisions.

As a rule of thumb, it is generally in your best interest to purchase the highest-end computer that you can afford. Since technology changes so rapidly, the better the system you get now, the longer its useful life will be, and the longer it will be before it requires upgrading. On the other hand, you can spend too much on a system if your needs are very basic. If money is a concern, it is a good idea to prioritize your needs–perhaps go with more RAM memory while sacrificing the speed of your CPU slightly. By taking a proactive, future-minded stance when buying a computer, you may be able to add to its useful life.

What you plan to do with your computer system will have a tremendous impact on what you need. For common investment tasks, such as portfolio tracking, you may not need all the bells and whistles of a high-end computer system. Technical analysis, on the other hand, requires more computing resources. It relies on the manipulation and graphical display of thousands of data points. Such tasks as this require a processor that can quickly perform the necessary calculations as well as a high-quality graphics card and monitor. If you are looking to store historical data for a large group of companies­—typical of fundamental screening programs—a large hard drive is a necessity. Real-time analysis will require a connection to either the Internet or a dial-up server, both of which require a modem or broadband access.

If you are looking to purchase a new system, the following base computer setup would allow you to avoid the inevitable obsolescence for a few years that all computer users ultimately face:

• Windows 98/NT operating system
• 500MHz Celeron or Pentium III processor
• 128 megabytes RAM (memory)
• 12 gigabytes hard drive
• 17-inch monitor
• DVD drive
• 56Kbps modem

Systems with comparable configurations can be purchased for around $1,500 from such respected mail-order firms as Dell, Gateway 2000, and Micron. Systems from IBM, Compaq, and Toshiba can also be purchased through retail computer dealers.

Once you have the platform (computer) you wish to use, you can move on to building the framework that will make up your trading strategy. This will ultimately be based on real-time price and volume data and the real-time analysis software with which you will manipulate it.

Time Is Everything

Timely and accurate quotes are critical for the day trader and momentum investor. If you trade on a short-term basis, especially intraday, a single tick can translate into hundreds, if not thousands, of dollars, depending on the size of your position. For volatile securities, such as Internet stocks, the price movements can be even more pronounced and rapid. In order to monitor the markets effectively, it is virtually a necessity for active traders to be wired directly to the markets, which means using real-time data.

Real-Time Quotes

Quotes are an integral part of a trader’s toolkit, especially when charted or plotted. They provide the trader with a map of how a stock’s price has traveled, and may provide clues to future price direction.

A current price quote provides the price of buying a security—the ask—and the price at which you can sell the security—the bid. The difference between the market’s best offer to buy a stock (bid) and the best offer to sell the same stock (ask) is known as the spread. Coupled with the trading commissions and tax liabilities, it represents the cost of trading into and out of a security. Spreads represent costs to investors and profits to market makers and dealers. Spreads are typically wider for small-capitalization stocks with low trading volume.

The price that the stock most recently traded at — called the last trade price — is also often referred to as a quote. On Nasdaq, market makers must notify the exchange of the price and the number of shares involved in a transaction within 90 seconds of the execution of an order. The last trade price conveys the price at which a security was sold, but does not reveal if the trade represented the purchase of a security by an investor from the market or the sale of a security by an investor to the market. The reported last trading price of securities with wide spreads often bounces up and down when transactions move back and forth between the bid and ask price. Before placing a trade, always examine the bid/ask spread and consider its cost in moving into and out of a security.

You will find several quote options available to you: How closely should you monitor stock quotes? Your investment holding period and investment style will determine how frequently you track a security’s price change.

Snapshot quotes represent the price at a point in time, just like a photograph. While the data was real-time at the point when the snapshot was taken, often users must refresh the quote to get the latest data.

A real-time quote service should go beyond supplying trading price statistics and actually provide the current bid and ask; the sizes of the bid and ask, which indicates the number of shares that can be purchased and sold at the current inside spread; the price, volume, and time of the last trade; the daily range of prices; and the volume.

Most useful to the active trader are dynamically updated quotes. Dynamically updated quotes are automatically refreshed every time a trade occurs in the market or when the bid or ask changes, effectively displaying market trades in real time.

Continuously streaming or dynamic real-time quotes are best suited for the active securities trader, where every second counts. However, these are also the most costly form of quotes. Users of real-time quotes not only pay a premium to the vendor, but also must pay an exchange fee. The various securities markets establish separate fees for individual and professional investors.

Historically, real-time quotes have been priced somewhat beyond the reach of the average individual investor. Monthly fees for quotes used to start in the neighborhood of $250. Information was fed to users through dedicated systems such as leased lines, satellite feeds, cable TV feeds, or FM radio broadcast.

The Internet allows more companies to provide real-time data because of the lower costs involved. As more companies fight for a piece of the pie, they try to attract business by providing more services, faster and more reliably, at a lower cost. In the end, the consumer benefits the most. Now, dynamically updated basic real-time quotes can be found for as little as $20 per month. Detailed real-time snapshot quotes can be found for free, with the Web site picking up both the datafeed cost and the exchange fee.

The trader also benefits from the availability of Nasdaq Level II feed through the Internet. While a standard Level I feed provides the current bid and ask, a Level II feed lists every bid and ask and their sizes for a given stock and indicates the market maker behind each bid and ask. The Nasdaq exchange consists of numerous market makers who compete with one another to fill customer orders for given stocks by displaying bid and ask prices for a given number of shares. The best bid and ask among the market makers are displayed as the inside spread on a Level I Nasdaq feed. This is in contrast to the New York Stock Exchange, which assigns a single specialist to facilitate all of the trades for a given stock. A Nasdaq Level II quote lists all of the competing bid/ask spreads, allowing the trader to judge the strength and size of the market behind a given stock.

Beyond real-time quote and volume data, many services offer a hodgepodge of additional services and functions. For the day trader, access to Nasdaq Level II data and Time and Sales data are important in that they allow you to “look inside” the market to identify trends in stock prices. Nasdaq Level II data, as mentioned earlier, lists every bid and ask and their sizes for a given stock and indicates the market maker behind each bid and ask. Time and Sales data gives you, in real-time, every trade and change in bid and ask price in a given stock.

Real-Time Technical Analysis

Technical analysis and day trading often go hand in hand. Technical analysis is flexible enough that you can use it on both an end-of-day and intraday basis—the only difference being the data is based on hours or minutes instead of days or weeks.

Day traders, by definition, buy and sell securities throughout the course of a trading day. Sometimes they use technical analysis programs to help them find potential trading opportunities. Real-time technical analysis programs collect and analyze price and volume data on a real-time, tick-by-tick basis.

Technical analysis attempts to capture the constant adjustments of price to the supply and demand for a given stock or security. In the short term, price often moves away from the long-term intrinsic value due to factors such as supply-demand imbalances (created as large institutions buy and sell large positions) or the market reacting emotionally to news or rumors. Charts, a key tool of technical analysis, reflect the price and volume movement of a security.

Beyond the real-time analysis capabilities offered by such programs, there are some other “extras” you should look for as well. These include charting in real-time (tick charting), creating your own technical indicators and trading systems, and creating technical screens. Furthermore, just as with real-time data services, having access to both Nasdaq Level II data and Time and Sales data is beneficial for real-time analysis. For more information on real-time technical analysis programs, refer to the Trader’s Reference article in the November/December 1999 issue of Computerized Investing (available at www.aai.com).

ECNs: Quasi-Exchanges

In day trading, as we have discussed, real-time data is essential. However, even if you have real-time data and can perform analysis in real-time using a technical analysis program, it is useless if you cannot execute the trade in real-time as well. If you are serious about day trading, therefore, you need to seek out a trading firm that allows you to place trades directly with an electronic communications network (ECN).

ECNs are quasi-exchanges in that they match buyers and sellers directly in a given stock so that both parties, in theory, are receiving the best price. Currently there are nine ECNs, accounting for roughly 30% of the trading volume on the Nasdaq.

ECNs operate in competition with Nasdaq market makers, which are the intermediaries in a “normal” Nasdaq stock transaction. When you place an order for a Nasdaq stock with your brokerage house, the company forwards your order on to a market maker for that stock who, in turn, will execute the trade—often from a personal inventory of stock. The catch is that, as the middleman, the market maker is looking to make money off the trade. This is done through the bid-ask spread, which the market maker pockets, while the expense is passed on to the consumer.

With ECNs, there is no middleman. Buyers are matched directly with sellers. Since ECNs do not receive revenue from the bid-ask spread, they charge a fee for every successful (filled) transaction.

Individual investors gain access to an ECN through a third-party firm—typically a day trading firm that, through special software and/or terminals, allows investors to place trades with the ECN. The firms tend to charge a monthly fee for this service, which can start at $100 a month.

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A Day in the Life: A Day Trader’s Story

Like a growing number of people, Anthony has decided he can make a better life by becoming a day trader. Taking a leave of absence from his architecture firm, he liquidated $50,000 of his investment portfolio. After attending a two-week day trading course at a day trading firm near his home in Los Angeles, he opened an account and was ready to enter the fast-paced world of day trading. The following is an account—in his own words—of his first day of trading.

Tuesday, December 21, 1999

4:30 a.m. PST

A combination of nervousness and necessity has me up at this early hour. Today begins my first day of day trading. I have three months to find out if I have the mettle and intestinal fortitude to make it. One of the veterans at the day trading firm I am using tells me I need at least six months to fully learn the process, but I don’t want to rack up six months of losses—if it should come to that!

With two hours before the open of the markets on the East Coast, I arrive at my day trading office. I decided to go with a day trading firm for a number of reasons. Number one in my mind was the fact that I will be surrounded by my peers. I find that it is easier when you have others around you from whom you can learn. They also serve as a support group when things are not going well. Secondly, the firm offers proprietary software that gives me real-time access to the market—Nasdaq Level II data, Time and Sales data, charting, etc.—as well as trade execution through an ECN for $15 per trade and profit/loss tracking for around $300 a month.

Figure 1. Nasdaq Level II Screen

Once I get situated, I go on-line to see what the buzz is on my stocks—Cisco Systems and Novellus. Both of these tech stocks have seen a decent run over the past several months, with Cisco up 105% year-to-date for 1999 and Novellus up 118%. Furthermore, and most enticing, are the healthy price swings both experience during the course of a trading day. It is these swings that I hope to capture in order to make money!

While I know that Cisco deals in computer networks and Novellus manufactures semiconductor production equipment, I could care less about their sales, product mix, or anything else—well, almost. The first order of business is to check out what the “Word on the Street” is regarding these stocks. The two message boards that I visit frequently are Silicon Investor (www.techstocks.com) and The Raging Bull (www.ragingbull.com).

The topic of conversation for Cisco this morning revolves around its announcement the day prior that it would purchase the land-based optical division of the Italian company Pirelli SpA. The opinions of the various posters to the Cisco board were mixed. It seems that Cisco’s venture into the European market caught many people off guard, especially since Pirelli is a relatively small fish in the European pond. There was also mention that PaineWebber upped its price target from $125 to $138.

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Activity was lighter at the boards for Novellus. Most were singing about the recent success in the stock price—up 52% over the last five days—as well as the company’s positive statements regarding its prospects for fourth quarter earnings and for the first half of 2000. Furthermore, the company recently announced a three-for-one stock split.

I also check the calendar of government announcements that could affect the markets. Here I learn that the Federal Open Market Committee is meeting to decide whether they need to increase interest rates. This makes me think that the markets will be a little sluggish today until the Fed makes its announcement, after which the market will make a significant move. Whether this movement would be for better or worse was all up to Alan Greenspan!

6:25 a.m. PST

Five minutes before the markets open. I have come up with my opening trades based on what I have seen on the message boards and the activity taking place on the Nasdaq Level II screen (Figure 1)—I will short 200 shares of Novellus NVLS and buy 200 shares of Cisco CSCO. The market makers have been beating down the bid and ask prices for Novellus leading up to the open and I have a feeling that people will be taking profits given its recent run. The market makers for Cisco have been less active, but I have a “gut feeling” that the stock will open higher.

6:30 a.m. PST

The market opens and I immediately enter my trades. Both of my hunches for the open were correct—Novellus opens down almost three points from yesterday’s close, while Cisco opens $0.75 higher than its prior close. However, things start to go bad quickly. Cisco immediately begins to fall while Novellus does not seem to want to go anywhere, bouncing within a tight trading range. I sit, eyes glued to my dual screens, watching the endless stream of data flow by on the Nasdaq Level II screens and Time and Sales displays.

6:36 a.m. PST

I hope that the rest of the day will go better than my first trades as a day trader. I sell some of my shares of Cisco for a loss of $125 while buying shares to close my short position in Novellus at the same price I sold them short. My biggest goal starting out is to limit my losses. If I lose an eighth, my strategy is to close the position. I have heard too many stories of people riding out a losing trade, hoping for a reversal, only to wipe out all their capital.

7:30 a.m. PST

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Well, I have survived the first hour of trading which, I am told, is often the most volatile period of the day outside of the last hour. So far, I am down “only” $25 on Cisco while I am up $500 on Novellus. My euphoria is short-lived, however—it seems I forgot about the small issue of commissions—$15 per trade with my broker. Since it took 32 trades to make my $500 in the first hour, I owe $480 in commissions. So, I am up $20. I guess I need to tone down my trading. The guy next to me says I am making a common rookie mistake—trading for the sake of trading. I need to pace myself so that I am making better-quality decisions and not giving back all of my gains in commissions.

Figure 2. Real-Time Newsfeed

9:00 a.m. PST

I do manage to settle down a little after the first hour of trading. I have now placed 56 trades over the first 2½ hours and for the day have netted a little over $200. It is disheartening to know that my trades have made me over $1,000, only to have the commissions eat them away.

I decide to follow a strategy used by some traders to stay out of the market while the East Coast people are at lunch. It gives me some time to do a little reading about the market and stocks as well as allowing me to recharge my batteries for the afternoon run.

9:25 a.m. PST

Returning from a visit to the washroom, I immediately learn the necessity of monitoring the market during the entire day. Novellus, which had been trading in a narrow band for close to an hour, rose over $4 in the span of five minutes! Looking at the newswires and chatrooms, I find nothing to explain the sudden jump.

10:03 a.m. PST

With the East Coast people coming back from lunch, another phenomenon may ensue called the “lunch effect”—the markets tend to rise immediately after the East Coast lunch hour. I enter a long position in Cisco, but am hesitant to get into Novellus. Since its spurt a half-hour ago, Novellus has again been trading in a very narrow range. I am looking for a point at which it may break out and make another move.

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10:20 a.m. PST

I am giving up on Cisco until the Fed announcement. Of the 15 round-trip trades I have made today for Cisco, I have made money on only six of them. In contrast, I have made money on 11 of 17 round-trips in Novellus.

11:13 a.m. PST

“Fed leaves interest rates unchanged, bias too.” Seeing this headline come through my real-time newsfeed (Figure 2), I immediately enter long positions in both stocks. The Nasdaq Composite is already skyrocketing upward; hopefully these two stocks will follow suit. The fun begins!

11:17 a.m. PST

The fun is short-lived. I make $0.5625 and $1.50 per share on Cisco and Novellus. Meanwhile the Nasdaq continues to soar—very frustrating!

12:12 p.m. PST

I am calling it a day with Cisco, following my small winning trade on the Fed announcement, I lose on the next three. I may be seeking out a different stock to trade in place of Cisco—one that has more action like Novellus. For the day, I gross $189 with Cisco. However, I placed 38 trades for Cisco for $570 in commissions. That leaves me $381 in the hole for the day. I guess I shouldn’t complain, considering that this is my first day. I now have 45 minutes with which to devote my full attention to Novellus.

12:51 p.m. PST

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The profit takers finally step in with Novellus. After being up almost 18 points on the day, a large-scale sell-off takes place during the last 30 minutes of trading. It is during this time that I make four round-trip short sales and gross over $1,200! Not a bad way to end the day.

1:01 p.m. PST

Well, I survived my first day financially intact. While I am, for the most part, pleased with the way things turned out, I wasn’t prepared for what went on here today. The pressure to succeed is enormous. Hopefully, I will become better at managing my emotional ties to the bottom line. Now, it’s time to grab some lunch and start preparing for tomorrow!

Market Wrap

For the day, I placed 88 trades (buys and sells) and, in doing so, racked up $1,320 in commissions. This takes my gross gain for the day of $2,763.89 down to a net gain of $1,443.89. Novellus carried the day for me, netting $1,825 compared to a net loss of $381.11 with Cisco. The biggest gains on the day for Cisco and Novellus were $175 and $400 (twice), respectively, while the biggest losses were $125 and $100. The longest trade I had for Cisco was 12 minutes, 14 minutes for Novellus. On average, I held a trade for just under four minutes.

Also ECNs provide a greater level of anonymity. While this may not be an issue for the typical individual investor, increasingly more and more institutions place orders through ECNs to mask their trading activity.

To a certain extent, unknown as yet, the future of both the New York Stock Exchange and Nasdaq will be determined by ECNs. Archipelago and Island, two ECNs, have registered with the SEC for exchange status, with others expected to follow in the upcoming year. This means they may be able to match orders for Big Board and Nasdaq stocks—providing broader market exposure than the individual systems and exchanges can.

Furthermore, eight of the nine ECNs have signed an informal agreement to link up to form a trading network—thus increasing liquidity for after-hours trading. In theory, this benefits users of the ECNs because it means that they will be getting the best buy or sell price, irrespective of the ECN they use.

Currently, orders for Nasdaq-listed stocks placed through an ECN during normal trading hours are routed through Nasdaq’s SelectNet system. However, there may come a time when the ECNs band together to challenge the SelectNet system for trades made during the day. It also remains to be seen whether ECNs will route trades to one another, although users will be able to see all of the bid and ask prices on the different ECNs. Many industry experts believe that this is the first step toward consolidation in the ECN market.

The Word on the Street

With the real-time data feed and analysis software in place, you are ready to trade, right? While you can follow a systematic methodology for your trading, which requires little in the form of market research, some like to get a feel for the individual stock(s) they trade as well as the market as a whole. To some extent you can glean this information by visiting some of the investment-related chatrooms and message boards available on the Internet. In fact, each trading day, a growing number of investors begin their day with a cup of coffee and the Internet.

Long before the U.S. markets open, these investors are checking to see what happened overnight on the overseas markets, previewing the whisper estimates for companies with earnings announcements scheduled for that day, and studying their stock charts. All this is done in the hopes of unearthing a nugget of information that will translate into a winning trade.

As the popularity of the World Wide Web has exploded over the past several years, so too has a new outlet where investors can converse among themselves and, perhaps, find that proverbial “diamond in the rough.” Message boards are on-line forums where people of similar interests can “converse” by electronically posting messages. Anyone viewing the board can read and respond to messages. Message boards should not be confused with on-line chat rooms, where the conversation occurs on a real-time basis between “live” participants in the chat room. Conversation on a message board takes place over a more extended period of time. After a message is posted, some time could elapse before anyone responds, if ever.

While computer bulletin board systems have existed since the early days of personal computers and on-line services, the Web provides a more centralized forum for communication. There are dozens of services where you can find discussions on individual stocks as well as broader topics such as technical analysis and day trading.

Message boards and newsgroups have become a favorite destination for investors, especially day traders—people looking to profit from small fluctuations in the price of a given security. While long-term stock movements are driven more by fundamental factors such as company financials, competitive position in the marketplace, economic conditions, and company management, short-term price trends can be influenced by emotion and market sentiment.

With a quick scan of a message board, you may be able to get a sense for what will be “driving” a certain stock for the day. Typical topics include discussions and analysis of company announcements, reports, fundamentals and technical factors along with warnings and projections of company and competitor announcements. Anything is fair play, including personal attacks, as investors with opposing opinions duke it out. Listening to other investors is a good way of gauging market sentiment.

Just as message boards and newsgroups have become a popular destination for investors, they have also become a spawning ground for spammers and scam artists. The ability to reach a large audience at relatively low cost is both an advantage and a burden for the Internet. Stock schemes that once required “bucket shops” with hundreds of operators trying to manipulate a penny stock can be duplicated on-line by one person with ease.

Posters at a message board have a wide range of investment expertise and a variety of motives. Moreover, because message boards provide a degree of anonymity, it is difficult to know whether the poster is attempting to manipulate the price or is passing along an honest opinion.

Manipulation of a stock’s price is of concern particularly when it comes to the more thinly traded penny and OTC stocks, where information and financial statements are harder to come by. Since a majority of posters to an individual stock’s message board probably have a stake in the company, they have a vested interest in the price movement of that stock. In the end, they would like others to buy the stock that they own. Likewise, they would prefer people to sell those stocks in which they have a short position.

On-line message boards and newsgroups can play an important role in your investment strategy­—as long as you perform your own analysis of what is being written. It is important not to be swept up in the emotions of a posting, otherwise you may find your investment dollars swept away. In the end, your own due diligence and common sense is the best protection for your investments.

Education Is the Key

This concludes our daytrading series. To review the full articles of the Trader’s Reference Guide, look for the following in the Computerized Investing archives at www.aaii.com:

• March/April 1999 Feature, “The Trader’s Reference Guide—Part 1”
• May/June 1999 Comparison, “Real-Time Quote Delivery Systems”
• July/August 1999 Feature, “The Trader’s Reference Guide Part 3: Messaging”
• November/December1999 Comparison, “Real-Time Technical Analysis Software”

While real-time data feeds, analysis software, and message boards can be useful in your trading, ultimately it is education that will have an overriding impact on your success, or lack thereof. Trading courses and articles such as this can only give you a taste of the world of daytrading. In the end, all of the dynamics of daytrading—the pleasure and the pain—will not come together until you are trading your own account with real money. Daytrading, like any other type of investing, carries with it a degree of risk. Learning all you can about daytrading and the markets before you attempt it certainly will not hinder your chances of success and may help limit your risk. Happy trading!