Paying Traders' Tuition

How do you become a successful trader -- and survive the learning experience, both financially, and emotionally?

I have only been trading since April 2002. I have done everything wrong, learned from mistakes, studied hard, searched charts for hours and hours, been depressed, been elated, and generally had a great time in trying to make daytrading my new profession.

I am just now feeling like I have a basic grip on how everything works, things are starting to click for me more often, and I feel like I have more moments of trading "in the zone." I've been working hard at making daytrading work -- for almost six months -- and I've discovered that it's true, this is hard work -- it is not a get-rich-quick scheme -- and you get out of it what you put in.

When I started, I certainly could have used some real-people war stories "from the trenches" to help me determine what was important to learn, what was not, and (the most difficult part) how to deal with day trading emotionally. I have collected below a list of things that have helped me along the way -- information learned from books and magazines, learned from other traders, and learned from my own experiences.

• Set your goals: "I want to be rich" may be a goal, but it's not well defined. Set specific goals. My goal was to be able to support my family financially as I have been doing for many years. To do this, I determined that a reasonable goal to strive for would be to average one dollar per share in my trade size (for example, averaging $100 profit a day when trading 100-share lots). This seems to be an attainable goal, and it is also nicely scalable once you have reached the goal.
  
  Assuming 250 trading days a year, each 100-share lot size for trading would earn $100 x 250 = $25000 per year. Given sufficient funds in an account, this can be scaled by trading larger blocks of shares (up to the point of where your trades start having liquidity problems because they are too large). If your financial goal is $100K per year, that can be attained by trading 400-share lots (4 x 25000). Of course, it's not quite as simple as that, because you may add refinements like scaling in and out of trades. But -- it's a specific goal -- and attainable
   
• Dedicate yourself to reaching your goals: If you are really serious about becoming a daytrader, you need to treat it like any other job -- get the training, learn as much as you can, and practice, practice, practice. You can learn a lot of things from books -- they are essential in getting a framework of knowledge into your head -- BUT -- "...there is nothing that can prepare you for the unbridled carnage..." (from the movie, "Trading Places" of course!) of the market when you participate in it. Get serious about your education -- and your apprenticeship.
   
• Study: Buy some books, subscribe to some magazines, and study it all. I bought 16 books. Every book has taught me something -- some books have taught me things you will not survive without. I subscribed to Active Trader magazine and Technical Analysis of Stocks and Commodities. Of the books I have read (so far), I highly recommend:
  • "The Disciplined Trader" by Mark Douglas -- covers the emotional and psychological side of trading
  • "Rules of the Trade" by David Nassar -- covers all facets -- invaluable information
  • "Tools and Tactics of the Master Day Trader" by Oliver Velez -- some fluff, lots of details about technical analysis and day trading techniques
  • "Bollinger on Bollinger Bands" by John Bollinger -- essential -- but don't read this until AFTER you have become very familiar with your trading platform, and you have testing and gotten a good feel for technical indicator usage
     
• Choose a direct-order-entry trading platform: This is the program that you will use to make trades. There are many choices (my website lists some). Because of my 30-year computer programming background, and my desire to have backtesting and trade-automation, I chose TradeStation .
  
  There are several features that you need to prioritize to help you make your decision. If you are trading smaller size (100, 200, 500 shares), you may want to select a platform that has low commissions for smaller trades. What types of charting and data do you need? Some platforms provide the data, and some require you to purchase a datafeed from another vendor.
  
  Some platforms charge you a monthly fee. The best way to choose is to visit several websites, download demo programs, and TRY them out. Selecting one with many features that you won't use immediately may be a good choice -- the platform gives you something to grow into -- features that you can take advantage of as you become more proficient.
   
• Study some more: Learn how the markets work. What's the difference between the Nasdaq market and the New York Stock Exchange? What do Market Makers do? What are Specialists? What are Short and Long orders, Limit orders, Stop orders? What is an ECN, and how are your orders handled differently with each ECN?
  
  A lot of this information you can get from magazines and books, but you also need to sit down in front of your trading platform and USE it until you understand how to place orders, how to cancel orders, how to exit orders, how to determine what trades to make, how to determine the number of shares to trade, etc.
  
   
• Pick technical indicators: Use your trading platform to monitor stocks as they change during the day. Try different time frames (I use 1, 2, and 5 minute to select trade entry and exit, and daily to get a general trend).
  
  Try the indicators that your charting package provides: MACD, Stochastics, RSI, Simple Moving Averages (SMA), Exponential Moving Averages (EMA), Trend Lines, Fibonacci retracements, Bollinger Bands, etc.
  
  Try different settings - 10, 20, 50 SMA, compared to 8, 13, 65 SMA, compared to 10, 20, 50 EMA. Try to determine what the indicators are telling you - how well do they help determine entry and exit positions?
  
  Try different stocks, and different sectors. Do stocks in one sector move in unison? Do some sectors follow the market indices, and some move the opposite direction?
  
  One of the biggest problems you can have with technical indicators is trying to use too many. Pick one or two -- learn how they work, learn what they mean, get a good feel for them. One common mistake that traders make is that as soon as their current indicator fails, they move on to another one. No indicator works perfectly -- they all give false readings sometimes.
  
  Look for agreement of indicators, look for agreement across time frames. Is the price bouncing off the top Bollinger Band on the 5 minute AND the 2 minute chart? Does RSI indicate that the stock is oversold? Is the general trend of the stock down? Is the the general trend of the stock's sector down? Is the general trend of the market down? Maybe it's a good time to short the stock!
  
  Look for general agreement among your various indicators and timeframes. If you wait for ALL indicators to give you an agreeing signal, you may never place a trade. You just need enough agreement to give you an edge - to make your probability of winning the trade slightly more likely than not.
   
• Find a Stock Scanner: You need to select a small number of stocks to monitor during the day. Stock scanner programs will search through thousands of stocks, looking for stocks that match the criteria you specify.
  
  Maybe you're looking for stocks that have an average price range of more than a dollar each day, and that have a share price from $5 to $50, and that are in the Biotechnology sector. TradingMarkets.com offers some good scanning technology. You can also purchase programs to scan for you - I use TC2000 .
   
• Start trading: You've already paid for the school books - now it's time to pay the tuition ;) Remember, the purpose is to LEARN -- if you feel like you will just be able to sit down and start making money, fine -- best of luck to you!
  
  A more conservative approach (that does not depend on luck) is to trade in small lots as you learn. You will lose money! Expect it. Start with enough capital in your trading account that you will not be hurt by losing part of it. Don't trade with money you can't afford to lose (one of the psychological reasons is that if you trade with "scared money," you cannot trade based on charts and trade data -- you will be affected by fear of losing your money).
  
  My decision was to trade in 100-share lots until I was consistently profitable. Consider the money you lose as you learn to be your "tuition" -- the same that you would pay a college to train you for a skill.
   
• Keep a trading log: During your first few hundred trades, you will make a lot of mistakes. You will also have some successes. Your goal is to learn what NOT to do - and to learn what works.
  
  If you take notes on your trades (as well as your emotional feelings, and any other pertenent information like world events or market happenings), you can review these notes to find patterns. Maybe you have a problem getting out of a trade after it has gone against you. Be honest in your log -- you don't have to show it to anyone else. The more honest and objective you are in evaluating your skills, the quicker you will be able to progress along the path to profit.
   
• Set rules: As you trade, as you make errors, as you have successes, develop a set of rules that give you a better edge with successes, and minimize the losses. Do you try to catch Opening Reversals in the first few minutes after the market has opened? They can provide spectacular winnings -- and just as easily make a big hole in your trading account when they don't go the direction you guessed.
  
  Here are some of the rules that I use:
   
  • Trade between 9:45 a.m. and 11:30 a.m., and 2:00 p.m. to 4:00 p.m. The first 15 minutes of the market opening is often difficult to play, unless you have a lot of experience, since the market makers are adjusting prices, dealing with overnight orders, and trying to set the opening price.
     
  • Never hold a position overnight. I follow this rule for my daytrading account because I have more control of trade entry and exit during the day -- and I'm not willing to gamble my money on gap openings.
    
    This rule may be modified or removed depending on the timeframe in which you trade. It is a good rule if you are strictly a day or range trader (trades lasting from a few seconds to at most a few hours). Of course, swing traders would not follow this rule, since their timeframe is up to a few days.
     
  • Before entering a trade, choose stop loss exit price based on charts (support, resistance, Fibonacci levels, etc.), and also choose profit exit price. If the loss exit price is too far from the current entry price (too high of a risk), don't take the trade. If the profit exit price is small compared to the stop loss exit price (risk-to-reward is not profitable enough), don't take the trade.
     
  • You set that Stop Loss -- USE IT! You chose the stop loss BEFORE you entered the trade because it was not an emotional time -- so in the heat of battle, trust your stop, and exit immediately if it is hit. Go back later and review the trade (for your trade log), and at that time, you can determine if the stop loss could have been chosen better.
     
  • You set the Profit Exit -- USE IT! Based on the volatility of a stock, you may determine that you want to get 20 cents per share, 50 cents, or whatever. Once your goal has been hit, either liquidate the trade, scale out (liquidate a portion of the trade), or tighten up your "trailing stop" so that you don't give back the profit that was your goal. The second or third options are preferable.
    
    Watch the Time And Sales screen - watch the Level 2 screen - determine if the momentum is slowing down. If the price blasts right past your profit exit, let it run! But as soon as it shows signs of weakness, make sure that you get at least the profit you planned.
    
    You may want to get out of a trade early, with a smaller profit, but make sure that you do this based on objective evaluation of the charts and bid/ask prices, and not because you get nervous about giving back ANY money. You need to give the trade enough room to do corrections -- but not so much room that the correction becomes a reversal.
     
  • Use Limit orders whenever possible. Set the price where you want to trade, don't let the market makers set it for you. The only exception I generally make to this is when I have a trade go against me and the price is moving so fast that it keeps passing my Limit -- then I'll either place a Limit outside the Bid/Ask range, or I'll capitulate and do a "just get me the heck out" Market order.
     
  • Enter trades on signals that are defined by your analysis. Don't enter a trade unless the conditions meet your criteria. Don't "feel lucky." As you get more skilled, you may occasionally enter trades that "feel" right, without being able to define the exact reasons -- but you should not be doing that until have had a lot of experience.
     
• Find one or more mentors: Maybe you know a trader personally? Or you may be able to find some good traders in various chat rooms. I have visited several chat rooms, and found that the TradingMarkets Traders Wire Interactive has everything I need. There are people there who can answer questions and who can coach and help you.
  
  Beware of trade rooms - they often have their own agenda. Find one (like TWI) that has traders in it who are actively trading, and not just hyping stocks. Lurk for a few sessions, watch, learn. Try to determine who the best traders are. Try to determine who are the people who are there for an ego trip -- and may provide you with misleading (or just plain wrong) information.
  
  You can learn a lot by watching the very best traders in action. When they make a trade, bring up the chart and try to determine their reasoning. Ask questions (but don't be a pest!). Remember, these people are there to make money -- if they don't answer you, they are probably busy!
   
• Place trades based on your own evaluation ONLY: Never ever place a trade because someone in a chat room called it out. You can certainly use the call as input -- but go check the chart yourself, and make sure that the trade follows your own rules.
  
  Maybe they called out the trade, but it's for a swing trade, with a 50 cent stop loss, and your pain level is no more than 10 cents -- pass on the trade. Maybe they got a hot tip from a friend - maybe they want to sound like they know "inside information" -- maybe they looked at the charts and liked the trade, but they read the chart wrong -- or maybe it's a good trade. Make sure YOU think it's a good trade before you put your own money on the line.
   
• After enough losing trades, take a break: This is a personal thing -- everyone will have a different level of pain. As soon as you start to feel frustration or emotion ("gotta get my money back"), walk away from your computer for a few minutes, and don't start trading again until you can trade based on the charts and data, and not based on your emotional state.
   
• After you've read everything, read more: Never stop learning -- the markets keep changing, and there are so many facets to them that there will always be more for you to learn. This will help give you a competitive edge ("knowledge is power"), and it will also keep you up to date on new products and rules and techniques.
  
  How do you get a raise as a "traditional" job? (No sarcasm, please!) -- you do the best you can in your current job, you learn everything you can, and you prepare for the next level. Then you prove that you have the knowledge and abilities for a promotion. In daytrading, you give yourself raises. You are responsible for your own destiny - the better qualified you are, and the more experience and knowledge you have, the more you are "worth" -- and the more money you can make.
   
• Use online references for learning and research: The TradingMarkets University website has hundreds of pages of lessons about all aspects of trading. It also has stock scanning tools to help you choose which stocks interest you. There are many other sites that have useful information, including Implied Volatility, Futures, Options, lists of members of sectors, list of the most active trading ECNs and market makers for each stock, and more. My website has links to many of these sites and various daytrading tools and references. Bookmark your favorite sites, and include them in your daily research.
   
• Recognize your psychological and emotional weaknesses: This is possibly the most difficult part of successful trading -- being able to control your emotional responses to the market, particularly during a trade. Fear will keep you from getting into a trade when your indicators say it's a good bet. Greed will keep you from getting out of a trade, waiting for just a little bit more money -- and will keep you in the trade as it reverses, and you give back all of your potential profit.
  
  Fear will get you out of a trade early, because you don't want to give back ANY of the potential profit. Greed will cause you to chase a trend, and get in "so you don't miss the boat" - often when the trend about to end and reverse.
  
  Egotism will keep you in a losing trade just because you must PROVE that you were right -- until the pain exceeds your threshold, and you exit the trade for a big loss. You must accept that your trades will not always be winners -- that doesn't mean that you were "wrong."
  
  Since nothing in the stock market is a "sure bet," you must recognize that the laws of probability are active. If you are wrong half of the time, but when you are right, you make twice as much profit as you lose (through your stop loss) on losing trades, you will be consistently profitable.
  
  Write your feelings and emotions in your trading log -- note every time that you do something based on an emotional response rather than a technical indication. Review your log to determine what emotional responses adversely affect your trading, and make a plan (see the Rules section, above) to correct the problem.
   
• Calculate the Reward/Risk: For each trade, determine how much you might gain, and how much you might lose. Factor in the probability of a "win," then objectively make the decision as to whether the reward is great enough to justify the risk. If the risk is too high, don't take the trade.
  
  For example, you might have a consolidation (where the stock price is moving sideways -- not trending up or down), and you have reason to believe that the stock may drop in price (maybe the sector is dropping, maybe $TRIN is negative, maybe $VIX is increasing, etc.).
  
  You look at the charts and see that if the stock were to drop in price, there is no significant support level for at least 30 cents down. You take the trade, with a 10 cent stop loss, and your Reward:Risk is 3:1 - probably a good bet. There are more extreme examples.
  
  You see that the price of the stock is hovering very close to the gap created when the stock opened in the morning -- and the gap is 75 cents away. However, the chart doesn't give any indication of whether the price will go up or down.
  
  In this case, your probability of winning is not as good as with the previous example, but your potential reward is higher, possibly signaling that you can enter the trade. Your goal is to select trades where your winnings significantly exceed your losses, over the long run. To do that, you need to pick trades carefully, and only enter trades that you think have a good chance of giving you a profit.

I have learned much over the last six months -- and I've also learned how much I do NOT know. I wish you the best of luck in your trading endeavors! Make a plan that stacks the deck in your favor, stick to your plan, and you'll be successful. It may take months, or maybe years.

The only indication that trading is not for you is that you are unable to follow your set of rules -- or that you are unable to start making a profit before you run out of money. Give yourself enough time to learn before you start expecting results -- and give yourself enough money in your daytrading account to weather Tuition -- and to handle drawdowns (losses based on probability swings when you have a string of losing trades).

Good Trading!

HamFon