So Begins The Summer

It’s that time of year when the activity in the markets begins to wane. When thoughts turn from double-tops to crop tops, from shorts to beach shorts, and from breakouts to summer breaks. Summer is here in the northern hemisphere, and traders everywhere are starting to take it easy. Including me. Which is why I haven’t posted any trades for a few days!

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Day Trading Is Like Living In The Matrix

Something I see beginning traders struggle with a lot is blindly following rules and then wondering why their trades don’t work out. It’s an honest mistake to make, after all, we are taught from an early age that rules are to be respected at all times. Formal education hammers into us the idea that to succeed in any endeavour we must follow a prescribed path, we must conform, we must stick to some predetermined plan. The trouble with that kind of thinking though, is that’s not the way the real world works.

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Mystic Meg vs. Day Traders

A reader asks: Why do day traders think they know the future?

To which my reply is simple: they don’t.

I should elaborate. Successful, profitable day traders, do not imagine for a moment that they know the future. Perhaps some of the unsuccessful ones believe they possess powers of clairvoyance like 90’s British celebrity fortune teller Mystic Meg. If so, that might explain why they are not making any money.

Snark aside, I understand the point of view of the person asking the question. To see profitable trades in hindsight, such as those posted on this very blog, it probably looks like the trader knew in advance how the market was going to move. It’s easy to imagine that we could fortell with great accuracy how the chart would play out. But to do so is to misunderstand how day trading works.

The job of a trader is not to predict with 100% accuracy where a price is headed. It is not to know the future. Our job is to weigh up the current price, where the price has been recently, and to consider other facts that may influence it. It is to combine all of that information with our knowledge of how prices commonly behave, and to come up with an opinion about where the price might go next. Not a predication, not even a forecast, just an opinion. So our job is not to know the future, it is to know the past and present and to use that knowledge to form an educated guess about the future.

Just like any other opinion or guess, sometimes we will take a strong view and other times we will be less sure of ourselves. For example, we might read a very positive news report about a company, then watch its stock price begin to skyrocket when the market opens. From that combined information we may form an opinion that for the next few minutes at least, the price is likely to rise further. If we hold our opinion strongly — perhaps we reckon there is a better than 50% chance of our guess being right — we might decide to buy some stock. Once in our long position (i.e. holding the stock), we would continue to re-evaluate the price and all other available information and update our opinion about what the price might do next. When our best guess is that the rise is over, we would sell our position and take our profit.

But what if our best guess was wrong? What if we bought into the stock and the price dropped? The answer, of course, is that we would sell back our position quickly to minimise our losses.

All this constant guessing might sound exhausting, but the thing is that most of the time we won’t be able to guess at all. Most of the time when we are looking at a chart we will have absolutely no idea where the price might go next. And that’s perfectly valid, because most of the time prices wander around in a relatively tight range and there’s no trade to take. We are looking for those “ah-ha!” moments when everything comes together — when we see a pattern we recognise, when the conditions are just right, when we think to ourselves I’ve seen this happen before, and there’s a pretty good chance it’s going to play out like it usually does. We’re not predicting the future, we don’t know what’s going to happen next, but we have a strong enough opinion about it that it’s worth risking some money to profit from it.

If we can form an opinion about short-term price movements that is correct more often than it is wrong, then in theory we are laughing all the way to the bank. And actually, we can be be wrong more often than we are right and still make excellent profits. But that’s the subject for another post!

Don’t Wait To Get Stopped Out

Here’s a trade that went wrong from the off:

It all started out so well. The setup was good and it looked like there was some momentum, but the price hesitated. My rule is if it doesn’t go well right away, get out. There’s no point hanging around to see if it will come good, because most of the time it won’t. I jumped ship with a single cent profit, which covered half the commission.

In this case the trade did eventually come good, and I went back in just a cent higher than I’d previously got out. This time there was no hanging around, momentum was there, and I rode it up for more than a dollar, thus taking more than a thousand dollars profit on BABA.

Emergency Exits

People quite often tell me they get killed in the market by being stopped out all the time. And almost equally as often they tell me that the trade they were stopped out of then turned around and became a winner, except they were no longer on board, adding insult to injury. They ask me if they are choosing bad stocks.

The thing is, you can’t really choose a bad stock as such, just a bad entry. Sure, if you pick the ‘right’ stocks you will find a higher rate of good entries coming your way, but even a poorly chosen stock can present a good entry. Just as a theoretically excellent stock can offer a bad one.

The problem these traders have is that they are waiting for their stop loss order to be hit. Stop loss orders are an essential tool for the day trader, and wherever possible I recommend having a stop automatically placed by our trading software as soon as our entry order is filled. But the job of that stop order is to be our emergency exit. It’s like an airbag in a car — a last line of defence if we lose control. If we are driving at high speed and see a collision ahead, we wouldn’t keep our foot on the gas and assume the airbag will save us, we would at least try and brake to stop the car before we hit the obstacle. The airbag is only there in case the brake doesn’t work, or if we cannot stop in time.

The stop loss order is the day trader’s airbag. It’s there to take us out of a trade if we lose our internet connection, or if our computer crashes before we end the trade, or if there’s some other kind of problem that means we are no longer in control. But as long as we are in control, we don’t want to rely on that stop order. If a trade doesn’t work out the way we envisage, there is no point waiting for the stop to get hit. We should always try to exit ourselves, and do so quickly with the minimum possible loss.

In the above trade, I was out with a 1 cent profit. That’s $10 on 1000 shares, so in reality a $10 loss once commission is taken into account. Had I waited for my stop loss order to be hit, I’d be looking at a $50 loss at least, which would be $70 after commissions. I could take a $10 loss on every core stock on my watchlist and still be better off than taking a single $70 loss! What’s more, I only need to make a tiny profit on one trade to easily cover my tiny loss. But if I rely on my stop and accept the bigger loss, I’m on the back foot with a defecit to try to recoup.

Having taken that tiny loss on BABA, the tape showed renewed momentum and the price made another break for it. There was no reason not to enter again, so in I went. Had I been burned by a larger intial loss, I might have hesitated on taking the second entry. But having got out quickly for essentially break-even, there was no reason to hold back.

Keeping losses small by exiting at the first sign of trouble means that we get to keep our account balance intact, it takes the pressure off trying to win back a large loss, and it means we can take multiple entries without hesitation or fear of the risk. Stop orders are for emergencies only.