Investment requires a certain aspect of the investor’s time and energy, not to mention knowledge and psychological makeup, to profit. Investing, including trading, breaks down into four general categories: 1) buy- and-hold, 2) position trading, 3) swing trading, and 4) day trading. The amount of time and skill necessary increases as you go down the scale from buy-and-hold to day trading. Buy-and-hold, basically a fundamental exercise in company and economy analysis, can be done once a year if necessary but more likely once a month, and drawdowns are of little concern because if the portfolio is properly diversified, whatever price declines that occur will likely be reversed over time. Position trading takes more fundamental and technical research because the positions will turn over more frequently and usually an exit strategy is necessary, forcing the investor to watch positions more closely, say once per month or every few weeks. Weekly charts are the most productive technical charts because the position investor or trader is not interested in the daily price oscillations. Swing traders hold a position between one day and several months but mostly for only a few days or weeks. This method requires daily charts and daily inspection for patterns and leadership. Finally, day trading is completely technical and based on technical criteria such as price, volatility, tendency to trend, liquidity, volume, and a myriad of other technical evidence. Before you select issues, you must decide what kind of investor/traders you want to become. Other considerations are discussed next.
1. Trading (Swing and Day)
Day trading requires a complete commitment to the markets. It requires time every day and night, whereas swing trading requires a daily commitment that can still allow time for a job. Day trading requires constant attention, excellent execution abilities, and high-speed price reporting. It is not for everyone, and it is not advisable for people who have other jobs and limited time to commit. Day trading can be accomplished through mechanical systems that are developed for that purpose, but even then, a heavy time commitment is necessary to perform the executions, to monitor the system, and perhaps to develop new systems.
The wise swing and day traders will select more than one issue to trade. In the stock market and the futures market, diversification is a necessity for many reasons. First, when a single issue becomes dormant in a small trading range and is difficult to trade, other issues with which the trader is already familiar can take its place. Second, following more than one issue increases the odds that a profitable trend will not be missed. Third, diversification, especially in issues that are not correlated, reduces risk. Thus, when screening markets with the criteria discussed next, anywhere from three to ten issues should be selected, watched, and traded. In Chapter 23, “Money and Portfolio Risk Management,” we will see that only a minimum commitment should be made to any one issue. Trading only one issue, and using more than the suggested initial capital in that one issue, substantially increases risk of failure.
Some traders, rather than concentrating on just a few issues, would prefer to screen through the entire marketplace for issues showing signs of an impending trend change. They program their computers to search for new highs and lows, gaps, one- and two-day reversal patterns, range and volatility changes, volume changes, moving average crossovers, and any number of other short-term indicators of possible trend change in individual stocks and contracts. From this information, they glean issues to trade over short periods and then go on to the next selected issues.
2. Choosing Between Futures Markets and Stock Markets
A swing or day trader must also make a choice about whether to trade in the stock market or the futures market or both. This choice is a personal one. The trader must consider a number of factors when making this decision. These factors include costs, personal risk preferences, preferred time horizon for trading, familiarity with each market, access to the proper equipment, and execution capability. Let us look at these factors in a little more detail.
3. Costs
Trading is a grueling, time-consuming process. It is not as glamorous as some recent movies make it out to be. Aside from the emotional strain of having to make instant decisions and instant executions, trading has numerous hidden costs that add up because of the many transactions necessary to profit. These transaction costs go beyond the commissions paid to the executing broker. The first cost is the initial setup of equipment. To trade, you must have not only a high-speed computer, excellent data feeds, and reliable, quick execution capability, but also a backup. You cannot afford to have your system go down during a short-term, especially intraday, trade. Other costs are commissions, slippage, missing the intended price during a fast market, limit days, and unexpected events, seemingly always occurring at a critical juncture. (The dog pulls the wires out of the computer, the cat walks across the keyboard and executes several orders, and so on.)
4. Risk
Each trader must determine her own level of risk tolerance. Futures are considerably more risky than stocks because they are usually traded with high leverage. Leverage is the amount of capital that can be borrowed to initiate and carry a position. Because futures can be entered into with a relatively small amount of personal capital, a trade can lose all its capital with a small adverse move. With futures, the danger always exists that an adverse move will eliminate the trader’s protective margin, requiring the trader to come up with more funds or be “stopped out.”
We investigate this leverage risk more thoroughly in Chapter 23. Stocks can also be leveraged, but usually not to the degree that futures can, and are, thus, not as risky to capital. This is not to say, however, that a stock trader cannot go broke as quickly as a futures trader can. Capital risk depends on many other factors than just leverage.
5. Suitability
Your experience in the markets determines the issues with which you are most comfortable. For beginners in technical trading, the slowest and least risky markets are the best. Once your trading experience provides enough confidence, you can enter other faster and more risky issues. Suitability also encompasses time available, how much should be invested in fancy quote and execution equipment, and so on. It is based on personal choice and preference.
6. Time Horizon
Day trading has many methods: scalping; using patterns, trend lines, or support and resistance; and analyzing short-term patterns.
Scalping involves taking small profits between the bid and ask prices of a stock. It requires close attention, excellent execution, fast-feed charting equipment, and communications, in addition to considerable experience. The competition is fierce between the scalper and the market makers, specialists, desk traders, and those others closely connected with the issues being traded. This type of trading is not for amateurs.
Regular day trading is trading an issue and closing all positions by the end of the day. It has an advantage in that there is no overnight risk because no position is held overnight. A variation of day trading is called screen trading. Screen trading uses technical analysis intraday shown on a computer screen to give signals. The bar lengths are determined by the trader’s ability to react quickly and accurately. Most commercial intraday technical analysis software divides trading into anywhere from single tick-by-tick, to 5-, 10-, 15-, and 60- minute bar lengths. From this data and software, almost any indicator or pattern can be programmed and used to identify opportunities. Again, however, it requires the time to watch positions all day and the equipment necessary to execute and watch entries and exits. Nevertheless, day trading has become popular. The new automated electronic exchanges where trades are executed immediately against the trading book have revolutionized day trading and made markets more accessible to nonprofessionals. The advent of the e-mini S&P 500 futures at the Chicago Mercantile Exchange is an excellent example of a futures contract that is executed almost instantly and has a margin requirement considerably less than its earlier, larger version.
Swing trading is more easily accomplished by amateurs. It is the holding of positions over several days or weeks, attempting to catch the small trends accompanying or counter to a longer trend. The swing trader can determine entry and exit prices during nontrading hours and can judiciously place orders for the next trading day to enter or exit positions. Many swing traders watch the market throughout the day, but it is often not necessary.
Of course, professional traders are active in all the preceding trading methods because they are intimately in tune with the markets.
7. Volatility
As we saw in some of the short-term trading patterns, low volatility is a difficult world in which to make profits. The breakout from low volatility to high volatility is where most of the profit is derived. Therefore, futures or stocks with low volatility are generally not good choices for trading. The transaction costs of exit and entry, the possible mistakes in execution, and other costs demand that the issue traded has enough price change to make a profit despite these problems.
8. Liquidity
Volatility, however, must be accompanied by liquidity. Price changes may be large (high volatility), but if no size is available for trading, this volatility is of no use to the trader. Liquidity is the ability to transact a meaningful number of shares or contracts easily and without bringing about a large price change. The difference between the quote price and the execution price is called slippage. Larger slippage is generally found in thinly traded stocks but may also occur with volatile, heavy volume stocks if the volume only occurs sporadically within the trading horizon or is the product of high-speed trading systems buying and selling the spread for large investment firms. For stocks, volatility can be measured using the ATR^. A more complicated formula is necessary for futures because of the different dollar value of point moves and the different margin requirements for each market contract.
Volatility usually is related to the consistent size of the bid and ask and the spread between bid and ask. A narrow spread does not guarantee liquidity because the bid and ask may be small. For easy entry and exit, high liquidity is a requirement. Trading is difficult enough without having to worry about whether an order will be executed close to the desired price. Each month, a section of Technical Analysis of Stocks & Commodities called “Futures Liquidity” shows a list of the most popular futures markets with their respective relative liquidity. These figures are based on the number of contract expirations that are traded, the total open interest, and the volume. The list also displays the margin and effective margin for each contract series.
9. Volume
Issues with constant heavy volume are usually issues that have liquidity, but they might not have sufficient volatility to profit. Volume is, therefore, a requirement for a trading issue, but it is not the final determinant. Liquidity and volatility are also required.
Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.
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