day trade your way to financial freedom 2nd e - chua 2007

•The Stock Markets•The Exchange System •NYSE Time Lines •Listed Stocks •The Specialist System •Who’s Who on the Exchange Floor •The SuperDOT System CHAPTERTWO The Big Board and Nasdaq..

2N D E D I T I O N

Copyright © 2007 by Sammy Chua All rights reserved.

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Library of Congress Cataloging-in-Publication Data:

1 Day trading (Securities) 2 Electronic trading of securities 3 Investment analysis.

I Title: Day trade your way to financial freedom II Title.

HG4515.95.C49 2006 332.64 ′ 2—dc22 2005031909 Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

•The Stock Markets

•The Exchange System

•NYSE Time Lines

•Listed Stocks

•The Specialist System

•Who’s Who on the Exchange Floor

•The SuperDOT System

CHAPTERTWO

The Big Board and Nasdaq 13

•The Over-the-Counter Market (OTC)

•NASD and Nasdaq

•Nasdaq Is a Negotiated Market

•Understanding Market Makers

•Information Is Power

•Nasdaq Service Levels I, II, and III

•Comparing the NYSE and Nasdaq

•Electronic Communications Networks (ECNs)

•Regulatory Framework

•Quick Quiz

Elements of Successful Trading 47

•Minimum Requirements to Begin Trading

Candlestick Charting Techniques 115

•Spotting Heavy Buying and Selling Pressures

•Comparing Buying and Selling Pressures

•Spotting Indecision with Candlesticks

•Understanding Intraperiod Activity

Preparing for the Open 177

•The Trading Day

•Other Market Indicators

•Direction of Market Trends

•Keep a Trade Journal

CONCLUSION 193

INDEX 195

WHEN SAMMY CHUA ASKED ME to edit his new book on day

trad-ing, I jumped at the chance As a reporter for Investor’s Business

Daily, I had covered day trading for several years Too many of the

day trading gurus I wrote about were interested only in getting novice traders intotheir shop, bleeding them dry, and then shoving them out the door when their cap-ital had run dry

Sammy Chua was an exception He has made a fortune using trading methodsthat I believe to be superior to the many other methods I have covered Now hewants to teach others how to succeed in this miraculous profession There is nohidden agenda with Sammy His zeal to teach is genuine and heartfelt He wants

to teach beginners to protect their capital and to avoid the psychological traps thatoften spell disaster for new traders Sammy Chua wants you to have the same suc-cess he has had

Day trading has come a long way in the past 10 years It is a risky occupation,but a small group of talented people have developed ways of lessening the riskand increasing the potential for profit Sammy Chua is number one on this list.Here’s a short version of his strategy: The controlling factor in day trading is,according to Sammy, supply and demand If demand for a stock is great, the sup-ply will decrease, driving the stock price upward If demand is poor, supply willincrease, driving the stock price down You don’t need a broker or an army ofresearch analysts to tell you when the laws of supply and demand are pushing astock up or down Just pay attention to what Sammy has to say in this book.Concentrating on supply and demand is liberating It frees the trader from theonerous chore of picking stocks based on the industry they represent Sammy oncedrove this home to me in a phone conversation He talked about making a goodprofit the day before on Corning I remarked that I liked Corning, because thecompany was in the rapidly growing fiber optics business

Sammy took a deep breath and said, “Pete, I don’t know what Corning does Idon’t care what they do I don’t know anything about any of the companies I trade

Peter McKenna

Editor

DAY TRADING IS THE MIRROR OPPOSITE of the buy and hold

strat-egy It means trading frequently, trying to capture small profits whilelimiting risk You do not buy a stock and hold it for years Goodtraders learn what makes stock prices move up or down, and they use this knowl-edge to make money on a daily basis

Consider, for example, just one of the important bits of knowledge this bookwill teach you: the theory of supply and demand as it applies to stock prices Wheninstitutions such as brokerages and mutual funds buy huge amounts of a stock—IBM, for example—the available supply of that stock will diminish This in turnwill drive the price of IBM stock upward A day trader who learns to spot stocksthat are under heavy accumulation can use that knowledge to catch a ride on IBM

as its price goes up The same is true in reverse If institutions are selling a stock,it’s supply will increase, driving the price down An alert day trader will short thisstock for a brief time as its price falls

When done correctly, day trading can help investors avoid the periodic lossesthat come with the traditional buy and hold strategy Since the first stock wastraded more than 200 years ago in New York City, the overall direction of the mar-kets has been upward For this reason, the buy and hold strategy makes sense ifyou want to hold stocks for several years

However, the market does not make this upward climb in a straight line Thereare periods of months and sometimes years when prices come crashing down ormove sideways This is the classic bear market Long-term investors who getcaught in these downdrafts can be badly hurt

Suppose, for example, that you put a lot of money into Lucent Technologieswhen it was trading near $20 in 1999 The stock soared to nearly $80 by January

2000 Everything was rosy Many long-term investors held onto tech stocks such asLucent, thinking they would go up forever, providing the money for retirement orcollege tuition or a new car in the years ahead Lucent was their nest egg

2 INTRODUCTION

But things turned nasty in 2000 and 2001 The tech sector collapsed and the ket came tumbling down It bears repeating that the market cannot go up forever.Something always brings it down Lucent now trades at about $3 Investors whobought Lucent in 1999 and held on have been left with next to nothing

mar-When the tech bubble burst, a day trader who understood the supply anddemand theory mentioned previously would have spotted Lucent, or any num-ber of other tech stocks They would have seen the selling pressure and shortedthe stock, making money immediately The rewards and risks of the day tradingstrategy are immediate; they are not long-term promises that may or may notmaterialize

This is a great time to be a day trader Although day trading has been around forseveral years, recent changes in technology and securities laws have opened it tosimple folks like you and me Today, we can trade from any location All we need

is an Internet connection and a computer We also have the ability to place ordersdirectly into the stock exchanges, which is almost like buying a seat on theexchange itself

Day trading is not for everyone To be successful, you have to love what you do

If day trading does not fit your personality, you will not last long For example,day trading can be risky You can lose money in a few seconds Risk taking comesnaturally to some people but shakes others to the core If you feel comfortable buy-ing only companies with strong, long-term fundamentals, then short-term trading,particularly day trading, is not for you But if your desire for financial freedom isstrong enough, if you are willing to develop the discipline it takes to trade success-fully, you have the right mentality to be a frequent trader

Before we continue, let me make an important point: This book covers manydifferent trading strategies You do not have to master all of them to be successful.Traders who concentrate on just one or two strategies almost always become suc-cessful faster than traders who want to know everything before they take theplunge The same is true in all professions Both general practitioners and heartsurgeons, for example, are doctors But heart surgeons are specialists and enjoymore success than general practitioners Be the heart surgeon and learn to special-ize in one strategy before moving on

INTRODUCTION 3

As you read this book, try to decide whether you have the type of personality ittakes to be a trader Remember, trading is an ongoing process of learning Youmust be willing to constantly adapt to the ever-changing market Trading requiresconstant reading, picking the brains of those who have already succeeded, and abulldog tenacity to learn your craft It can be exciting, even exhilarating, whenthings go your way There is no limit to the profits you can earn Your successdepends on how much effort you are willing to commit to learning Let’s getstarted

CHAPTER 1

An Overview

• The Stock Markets

• The Exchange System

• NYSE Time Line

• Listed Stocks

• The Specialist System

• Who’s Who on the Exchange Floor

• The SuperDOT System

You will not be able to execute these strategiesunless you learn how the stock markets work.

Every day, millions of shares move back and forthfrom one investor to another How is this done?

Who are the people who execute these trades forinvestors? How do you get the best price on yourorder? Which electronic routing systems are thebest for day traders? What does all this back-and-forth mean to the day trader? These are the basics

Learn them well

In the United States, stocks are bought and sold

in two different venues: stock exchanges and

over-the-counter markets (OTCs) This chapter explores

the differences between the two systems, larly the differences that will affect your career as aday trader

particu-THE EXCHANGE SYSTEM

The largest stock exchange in the world, tradingmore than 3,000 stocks, is the New York Stock

Exchange (NYSE) The NYSE is situated on WallStreet in New York City It is also known as the BigBoard and is considered the center of the stock-trading universe The NYSE was created in 1792 by

24 traders who got together to trade a few shares intwo small, local companies From this humblebeginning, the stock market grew into the beast it

is today Most day traders, however, never set footinside the NYSE Including the NYSE, there areseven stock exchanges in the United States, but theNYSE is the granddaddy of them all The othersare smaller, regional exchanges that look to theNYSE as the leader

An exchange is a place where buyers and sellersphysically get together on a central trading floor tobuy and sell Floor trading is essentially an auction

in which price is determined by supply anddemand The trades may be routed by computer,but they all eventually come to the market floor forexecution The exchanges are membership organi-zations The members trade securities on behalf of

THE STOCK MARKETS

D AY TRADING INVOLVES THE FINE ART of finding stocks that

will come under buying or selling pressure This pressure makes the stock price move significantly up or down That’s the first step Knowing when these stocks are likely to make their move is the second step The final step is executing a trade to capture a brief portion of this move, making a profit in the process.

1865 The average daily volume is about 34,000 shares

traded for 141 companies

1900 Volume grows to 505,000 shares per day for 369

companies

1920 Volume is 825,000 shares per day for 689

companies

1940 Down to 750,000 shares per day for 862

companies, volume explodes

1960 Average daily volume rises to 3 million shares for

1,143 companies

1980 Volume is 44 million shares per day for 1,570

companies

1987 Largest one day percentage drop occurs.

1990 Volume is 157 million shares per day, 1,774

companies

1997 Volume is 525 million shares per day for 3,028

companies

1997 All-time record 1.2 billion shares are traded on

mini-crash day, October 27

2000 Both the biggest point jump (499.19) and the

biggest point slide (617.78) occur

2001 Trading in fractions ends.

2003 NYSE Composite Index is relaunched using revised

methodology

2005 ARCA and the NYSE merge.

TECHNOLOGICAL ADVANCES

1878 The first telephone is installed.

1978 The first electronic linkage to other exchanges is

installed

1984 Orders are electronically routed to the floor using

SuperDOT system

1995 Hundreds of old TV-style monitors are replaced with

modern flat-panel displays in the world’s largestinstallation of this technology to date

1996 Floor brokers start using handheld wireless

information tools

LISTED STOCKS

Stocks traded on the NYSE are called listed stocks.

This means the underlying company has met therequirements necessary to list its stock on theNYSE One requirement, for example, is marketcapitalization To be listed on the NYSE, a companyusually must have a market capitalization of atleast $100 million (Market capitalization is deter-mined by multiplying the stock price times totalshares outstanding.) These rules were designed toprevent the Mafia from getting money-launderingcompanies listed on an exchange

Stocks with a large market capitalization are

called large-cap stocks They are usually

estab-lished companies For example, IBM, founded in

1911, has a market capitalization of $124.64 billionand is a large-cap stock traded on the NYSE Otherlarge-caps traded on the NYSE include DuPont,Ford, Coca-Cola, General Electric, Alcoa, and

AT&T It is important to remember that large-capstocks traded on the NYSE are not as volatile asOTC stocks This can be an asset or a liability to theday trader However, some large-cap stocks, eventhough they trade on the NYSE, are volatile.

Energy stocks and pharmaceuticals are examples

Before I discuss how these stocks are traded,here is a list of terms you should know They apply

to the workings of both the NYSE and the OTC:

Best bid The price a buyer is willing to pay to buy a

stock

Best ask The price at which someone who owns a stock

is willing to sell it

Broker One who arranges the sale of a stock.

Dealer Usually a brokerage, such as Charles Schwab

Bro-kers sell the stocks that dealers keep in their inventories

THE SPECIALIST SYSTEM

Exchange trading is carried out by a person called

a specialist Specialists control the auction process.

Their job is to match buyers with sellers The cialist looks at an electronic order book of bids andasks and matches them according to price andquantity The specialist, for example, will match aperson willing to buy 100 shares of IBM at $80 with

spe-a person willing to sell 100 shspe-ares of IBM spe-at $80

Specialists are the people you see running around

on the floor of the NYSE The specialist and his orher clerks are assigned responsibility for one ortwo stocks They handle all bids and offers forthese stocks

There is more to a specialist’s job than matchingbuyers and sellers They are expected to maintain

an orderly and fair market When there is an excess

of buy or sell orders, making it impossible tomatch orders evenly, the specialist steps in Theremay be 1,000 people who want to sell IBM at $80,for example, but only 100 people who are willing

to pay this price This situation, called an order

imbalance, sometimes causes trading to be

tem-porarily suspended An opening delay usuallyhappens when a news event or extreme imbalance

of orders prevents the stock from trading when themarket opens The specialist has 15 minutes fromthe opening bell to determine a price range atwhich the stock will begin trading

A specialist can delay an opening or halt tradinguntil a proper balance of buyers and sellers isachieved Usually, the stock will start trading at aprice far different from its previous price Someday traders try to profit from these imbalances,which occur frequently

Specialists profit from the spread, the difference

between the bid price and ask price, for each market-order transaction in which a spread exists

A market order is an order to buy or sell a stock atthe market’s current best displayed price

A good specialist will be assigned ity for more stocks than the usual one or two Spe-cialists may trade for their own firm’s accounts aswell, buying low and selling high to make aprofit

responsibil-Specialists are predictable Novice day traderswho want to trade stocks on the NYSE should get to know the habits of the specialists they are

ANOVERVIEW 9

dealing with There are several day trading firmswhose members make a good living just by follow-ing the actions of the specialists Their aim is tocapture small profits several times a day, just likethe specialist

WHO’S WHO ON THE EXCHANGE FLOOR

In addition to the specialist, here are the peoplewho make the NYSE hum:

Specialist’s clerk The clerk sits next to the specialist.

They stand ready to maintain the electronic order bookand report executions The order book contains buy andsell orders at different prices, including the current marketprice These are the orders and prices that must bematched

Floor brokers Brokers usually represent big-name

bro-kerage firms They handle large (block trades) or sensitiveorders The brokers deliver these orders to the specialists

They are allowed to negotiate orders with the specialists orother floor brokers in the presence of a specialist

Floor clerks These people deliver orders from the floor

brokers to the specialists

Member firms A big-name brokerage firm that has a

seat on the NYSE If your brokerage firm is not a member,your order will pass through another firm that is a member

Floor traders These are independent traders They trade

for their own accounts and can represent institutions whencontracted

Customer A customer can be a day trader, an investor, or

a large institution Generally, they are not present on the

floor, but their orders are the cause of all the activity yousee on the floor

There are 17 trading posts on the trading floor.Each post is semicircular and about 15 feet across.Each post trades an average of 150 securities Thespecialists are stationed outside the trading posts

in designated spots The clerk sits inside the postand communicates with the specialist through awindow Display monitors hang above the postwindows so the clerk and the specialist can watchthe floor broker and the order books at the sametime Huge conduits rise up from the trading floor,carrying data lines to the exchange computers

THE SUPERDOT SYSTEM

Buy and sell orders on the NYSE are routed to theexchange floor by an electronic system calledSuper Designated Order Turnaround, or Super-DOT The best way to understand the miracle ofthis system is to compare it with the routing meth-ods used before the SuperDOT was implemented.Figure 1.1 gives you an idea of the long processneeded to route orders in the old days As you cansee, getting a trade executed in the old days tooktime The trader called a stockbroker and placed theorder The stockbroker called the order in to thetrading desk The desk relayed the order to a floorbroker at the NYSE The order was then passed to afloor clerk, who would give it to the specialist forexecution After the order was executed, a confir-mation (or trade report) would flow backwardthrough the same process until it reached the trader

Every transaction required multiple pieces ofpaper, which were crumpled up to distinguishthem from paperwork that might have been acci-dentally dropped That was why, in the old days,the floor of the stock exchange was littered withsmall scraps of paper The SuperDOT system haseliminated most but not all of the paperwork.

Paper is still used for negotiating large and specialorders

SuperDOT is fast and reliable Orders godirectly to the specialist This minimizes the timeinvolved, and trade reports are made within sec-onds, except on the busiest days Brokers who

trade on this system have what is called direct

Customer Places OrderTrading DeskFloor BrokerFloor Clerk

Customer Gets ConfirmationTrading Desk

Floor BrokerFloor ClerkSpecialist Executes Order

1.1 Historical Buy and Sell Order Routing System Used on the New York Stock Exchange

䊳WHEN THERE IS AN EXCESSof buy and sell orders, the specialist steps in

Customer PlacesOrder

SpecialistExecutes Order Customer GetsConfirmation

1.2 SuperDOT System (Super Designated Order Turnaround System)

䊳COMPANIES WITH SMALL MARKET CAPSare handled on the Bulletin Board and the Pink Sheets

ANOVERVIEW 11

access to the NYSE market If you are a day trader

and your broker is a NYSE member, your orderwill most likely be delivered through SuperDOT

A quick look at the flowchart in Figure 1.2 givesyou an idea of how streamlined this new process

is It is important to note that SuperDOT is not anautomatic-execution system Orders are routed

electronically through SuperDOT, but they are stillexecuted by specialists If there is an order imbal-ance or if you have placed a limit order, SuperDOTwill automatically deliver your order, but thatdoesn’t guarantee that your order will be exe-cuted If there is no match, the trade will not befilled ●$

CHAPTER 2

The Big Board and Nasdaq

• The Over-the-Counter Market (OTC)

• NASD and Nasdaq

• Nasdaq Is a Negotiated Market

• Understanding Market Makers

• Information Is Power

• Nasdaq Service Levels I, II, and III

• Comparing NYSE and Nasdaq

• Electronic Communications Networks (ECNs)

• Regulatory Framework

• Quick Quiz

While the NYSE trades large-cap stocks, theOTC is home to smaller companies Many technol-ogy companies with small market capitalizationtrade over the OTC They are often less establishedthan companies found on the exchanges Forexample, eBay, a seven-year-old tech companywith a market capitalization of $17 billion, trades

on the OTC

Over-the-counter trading is done by people

called market makers You never see these men and

women, because they work out of sight at puter terminals across the country In contrast tothe NYSE, where stocks are put up for auction,market makers buy and sell from their own inven-tory of stocks

com-Numerous types of securities are traded on theOTC, including but not limited to the following:

● Corporate stock

● Corporate bonds

● Municipal bonds

● U.S government securities

● U.S government agency securities

Of these, day traders are mainly interested in porate stock

cor-NASD AND cor-NASDAQ

Market makers trade through an electronic systemrun by the National Association of Securities Deal-ers (NASD) It is called the National Association ofSecurities Dealers Automated Quotation System,

or Nasdaq It is the NASD’s equivalent of theNYSE’s SuperDOT system

Nasdaq began operating in 1971 The purpose

of Nasdaq is to collect and provide real-time, firmquotes on selected OTC stocks through its auto-mated quotation system This system was a majoradvance for OTC trading Previously, if dealerswanted to sell a stock for $35, they had to get onthe phone and find another dealer willing to pay

$35 They had to keep calling until a buyer wasfound The process was cumbersome and slow.Essentially, Nasdaq is a real-time classified ad.Traders post their buy and sell orders for the rest ofthe trading world to see It also provides a means

THE OVER-THE-COUNTER MARKET (OTC)

T HE OTC DIFFERS FROM THE NYSE in important ways However,

it, too, uses a state-of-the-art computer system to route trades There is no central trading floor in the OTC market Transactions move from computer to computer, over the Internet, or over electronic trad- ing platforms.

THEBIGBOARD ANDNASDAQ 15

to get orders executed Nasdaq trades some of thebiggest names in technology, such as Intel andMicrosoft The Nasdaq system allows large institu-tional buyers, market makers, brokerage houses,electronic day traders, and online investors tocome together to communicate their trading inten-tions in real time It is a high-speed, state-of-the-artcomputer network bazaar

Securities traded on Nasdaq are grouped intothe following three classifications:

●1 The National Market Securities (NMS) are the highestclassification, or tier, of Nasdaq stocks There are morethan 4,000 NMS stocks These stocks meet the higheststandards with regard to annual net income, price pershare, number of publicly held shares, and so on Theyare considered large-cap stocks

●2 The small-cap market is the next group, comprising morethan 1,300 securities They have smaller market capital-ization than do large caps

●3 Companies with very small market capitalization are dled on the OTC Bulletin Board and the Pink Sheets

han-Day traders are mainly interested in the NMStier of stocks—the large caps

NASDAQ IS A NEGOTIATED MARKET

While the NYSE requires a specialist to act as anauctioneer or intermediary, the Nasdaq allowsbuyers and sellers to interact directly without an

intermediary That is why Nasdaq is called a

nego-tiated market The buyer who offers the best price

will get taken care of first The seller offering the

lowest price will likewise get a faster responsefrom buyers Nasdaq is automated and simplified.Remember, at the NYSE, stocks are sold at auction

by an intermediary Nasdaq stocks are bought andsold on a best-price basis

UNDERSTANDING MARKET MAKERS

Market makers make day trading exciting Theyare dealers who buy and sell stocks on behalf oftheir clients or for their own firm They provideliquidity for their customers and make the Nasdaq

market viable When a stock is liquid, it means the

price will not be greatly changed by heavy buying

or selling

Market makers make money by capturingmomentum moves They also make money captur-ing the spread, just like NYSE specialists Marketmakers also act as commissioned representativesfor large financial firms or mutual funds As reps,market makers become brokers acting on theirclient’s behalf to buy or sell a security When marketmakers act as intermediaries for a big firm, they getpaid a commission The commission is usually thespread between the inside bid and the inside ask Inmost cases, small orders from traders like you and

me come from a market maker’s own inventory

The term market maker refers to a securities firm

as well as an individual Examples are GoldmanSachs and Morgan Stanley, firms that are regis-tered to buy and sell specific securities As marketmakers, they abide by Nasdaq rules when making

a market Market makers are required by Nasdaq

to maintain a two-sided market This means they

are required to post both a bid price and an askprice at the same time.

Unlike specialists and floor brokers, marketmakers work in offices, using computers and thetelephone to make the market One market makermay handle a single security or 25 at a time Thereare approximately 60 market makers trading the6,000 securities on Nasdaq Usually, the big-namestocks have 40 or more market makers, while thesmaller-name stocks have just a few Tracking andunderstanding their methods is vitally importantfor the day trader

The Three Main Responsibilities of Market Makers

●1 Execute transactions for their clients The most

impor-tant function is to execute orders for clients at the bestpossible price They do this by interacting with other mar-ket makers online or by telephone

●2 Keep an orderly market This means they must prevent

dramatic fluctuations in the price of a stock that comesunder heavy buying or selling pressure To create this liq-uidity, market makers must provide a two-sided marketwithin the market bid/ask price Liquidity happens asmarket makers fulfill their obligation to make marketsthroughout the trading day They must advertise to sell at acertain price whenever they make a bid to buy a stock at

a certain price That’s why it’s called a two-sided market.

●3 Trade for the firm’s proprietary account Market makers

use inside knowledge, experience, and technology tomake profits on a daily basis They take profits on thestocks they make a market in, but they also take specula-tive positions on the possibility of future price movements

of those stocks—depending on the time of day, the marketconditions, and the existing order flow

Different Types of Market Makers

It is important for day traders to be aware of thedifferent types of market makers and understandthe trading patterns they create Here’s why.Market makers do the lion’s share of trading onthe OTC Big market-making firms, such as Gold-man Sachs, Paine Webber, Salomon Brothers, andMerrill Lynch, represent large institutions, such aspension funds and mutual funds They buy andsell for these clients They also trade for their ownretail customers and their own trading accounts.The sheer volume of this trading can have a dra-matic impact on stock prices

You can watch market makers trading onwhat’s known as Level II computer screens Pat-terns will emerge if you watch them over time.They repeat certain actions throughout the day,giving you insight into their true buy and sellintentions and market direction Keep in mind thatmarket makers do not always make the right deci-sions The market as a whole is always more pow-erful than any single market maker

The following will help you recognize the ous types of market makers as you watch Level IIscreens Trading symbols are given for each firm.The information available on Level II is discussed

vari-in detail later vari-in this chapter

INSTITUTIONAL FIRMS

GSCO Goldman Sachs & Co

SBSH Salomon Smith Barney

LEHM Lehman Brothers

MSCO Morgan Stanley & Co

THEBIGBOARD ANDNASDAQ 17

These worldwide firms do the largest ings They cater to big institutions like mutualfunds and pension funds They have well-financedresearch departments They are the most powerfulmarket makers and can set the market on firewhen they trade

underwrit-WHOLESALERS

MASH Mayer & Schweitzer, Inc (Charles Schwab)

HRZG Herzog, Hein & Geduld

SLKC Spear, Leeds & Kellogg

SHWD Sherwood

NITE Knight/Trimark

MHMY MH Meyerson & Co

These firms do no retail business and provide noresearch They simply make a market for otherfirms

WIRE HOUSES

DEAN Dean Witter Reynolds

PAIN Paine Webber

PRUD Prudential Securities, Inc

MLCO Merrill Lynch & Co

These are big, full-service brokerage firms Theyprovide financial advisors and brokers They makecommissions from order flow and a growing cus-tomer base

REGIONAL FIRMS

PIPR Piper Jaffray

SWST Southwest Securities, Inc

DAIN Dain Bosworth Inc

WEAT Wheat, First Securities

These are smaller brokerage firms with less sure to the markets They are cautious traders

expo-INVESTMENT BANKS

HMQT Hambrecht & Quist, Inc

MONT Montgomery Securities

COWN Cowen & Co

These are strictly underwriting firms They helpcompanies complete initial public offerings (IPOs)and secondary offerings They are not primarymarket makers, but they will trade stocks theyunderwrite to help create market activity

Market Maker Recap

To recap, the market maker must:

● Execute orders for their firm’s clients

● Keep an orderly market

● Trade for the firm’s proprietary accounts

INFORMATION IS POWER

Day traders need as much information as they canget At the very least, they need to see who is buy-ing, who is selling, and the prices offered by eachbuyer and seller Both the NYSE and the OTC pro-vide information about the trades taking place ontheir systems The information is flashed on a Level

II computer screen But the information provided

on NYSE Level II screens is basic, not nearly enough

to be used to day trade If you look at a NYSE Level

II screen, for example, you will see large gaps in thebid and ask prices On a Nasdaq Level II screen, youwill see no such gaps (see Figure 2.1)

Figure 2.1 compares the details shown on aNYSE Level II screen with the information shown

on a Nasdaq Level II screen Remember, for daytraders, who rely on Level 2 information to makedecisions, information is critical The Nasdaq pro-vides far more information than the NYSE

NASDAQ SERVICE LEVELS I, II, AND III

NASD is a self-regulatory organization Its ber firms use Nasdaq terminals that display real-time bids and offers, size of quotes, and otherinformation Nasdaq sends this information electronically to all market participants on threelevels

mem-Level I

Available to stockbrokers and most onlineinvestors, Level I provides the following basicinformation:

Highest bid and lowest offer at any given time

(called the inside market)

High and low for the day

Volume for the day

Price change from previous day

Direction of last trade (uptick or downtick)

Size of highest bid and highest ask

Last transaction price

Level II

Level II not only shows the size of the best bidsand offers, it also shows the depth Depth is themarket that exists behind the best bid and offer,

also called the outside market Level II shows the

next bids and offers for several levels up and downfrom the best price This is very important to theday trader It’s like sonar for a submariner or fieldmaps for Napoleon It is the best crystal ball youcan have to determine the short-term direction of astock price

Here’s another way of looking at the depthoffered by Level II Let’s say Buyer A is bidding

$65 for a stock on Nasdaq On Level II, sellersare offering the stock for $65.25 Buyer A’s bidand the sellers’ offer is the best bid and offer atthe time Also listed on the screen are the out-side market bids and offers, the next levels ofbids and offers down from the best bids andoffers In the outside market, Buyer B is offering

to buy the same stock for $64.75 while anotherseller is offering to sell at $65.50 In order forBuyer B’s order to be executed, Buyer A’s orderhas to get filled first and stock prices have to fall

to $64.75

Level II shows the names and quotes of all tered market makers in each Nasdaq security Daytraders and online traders can access Nasdaq’sLevel II through electronic communications net-works (ECNs), which are explained later in thischapter Each of these systems has its own name,which appears on the Level II screen

regis-The following information is displayed on theNasdaq Level II screen:

THEBIGBOARD ANDNASDAQ 19

Which market makers are playing

Which ECNs are participatingBids and offers

Size of the market (for both market maker and ECN)

Time that the market maker placed or refreshed a bid or offer

Time of each executed tradePrice of each executed tradeSize of each executed trade

2.1 NYSE Level II versus Nasdaq Level II Information

THIS SECTION GIVES THE ACTIVITY ON THE STOCK:

The change in price from the previous day, the highest and the lowest price of the day.

Previous closing price, volume, spread the ratio of the sizes between the bid and ask price.

NAME OF THE STOCK

If you look at the first 7 levels

on the bid side and compare the two, you will notice that the prices of IBM goes from ? down to ? (a difference of

$?) while INTC only drops from

? to ? (a ence of $)

differ-THIS IS THE TIME AND SALES COLUMN

aka “prints.” Any transaction that occurs will show up here.

䊱NYSE LEVEL II SCREEN

IBM is a listed stock that is traded on the NYSE

䊱NASDAQ LEVEL II SCREEN

INTC is an over the counter stock traded on the NASDAQ

COMPARING THE NYSE AND NASDAQ

The NYSE is an auction house maintained by cialists who receive orders and execute them bymatching them with other orders and sometimeswith orders from their own account The special-ist quotes at the inside bid or inside ask if thespread becomes too wide In this case, the special-ist will trade from his or her own inventory Thesefactors are apparent to the trader on the computerscreen All other factors such as strategy are notapparent, but sometimes they can be deduced bywatching the specialist’s trading patterns Theorders received by the specialist flow electroni-cally through SuperDOT Only under unusualcircumstances do orders flow manually through afloor broker Price movement on the NYSE isorder-driven, because the specialist matches bidsand asks from the order book Movement oforders from one side to the other (buy to sell, orsell to buy) creates price movement The NYSE is

spe-a trspe-aditionspe-al mspe-arketplspe-ace; its stocks spe-are estspe-ab-lished companies with high market capitaliza-tion The NYSE is a stable marketplace becausespecialists can stop trading if the market’s orderflow becomes extremely maladjusted or out ofbalance

estab-Nasdaq is a negotiated marketplace withoutspecialists It is totally computer-driven Marketmakers compete in this marketplace If Nasdaq

is dominated by anything, it is a nationwidecomputer bulletin board (the OTCBB), whichlists all available quotes It is a modern techno-logical phenomenon Nasdaq market makers are

required to display quotes for the stocks they aremaking a market in Nasdaq stocks tend to besmaller-capitalization stocks with high growthpotential

Which Market Is Better for Day Traders?

The answer depends on the individual Nasdaqprovides more price movement This higher intra-day volatility also generates more intraday profitopportunities But large price fluctuations couldalso mean greater losses This means that tradingthe Nasdaq requires more expertise and knowl-edge

However, many traders prefer the NYSE It ismore stable and can absorb a lot more volume.These traders make a good living by following thespecialist, but due to the narrower range on NYSEstock prices, most traders take profits of less than

$1 on their intraday trades

The bottom line: If you are willing to take therisk, Nasdaq offers greater rewards As a daytrader, my market of choice is the Nasdaq It pro-vides good opportunities every day

ELECTRONIC COMMUNICATIONS NETWORKS (ECNs)

Electronic communications networks (ECNs) arequasi stock markets They are used by both NYSEtraders and OTC traders Recently, the NYSE hasallowed traders to trade directly with each othervia electronic communications networks (ECNs).They function as an exchange floor, except thatorders are filled electronically and there is no

THEBIGBOARD ANDNASDAQ 21

trading floor Currently, two of these networkstrade stocks that are listed on the NYSE They areINET and ARCA ARCA recently merged with theNYSE Although the future is unclear on thismerger, one thing is sure: Speed will increase andtransaction costs will decrease Both very goodthings for the trader

ECNs work on a first-come, first-served basis Ifthe orders match, these transactions usually take afraction of a second When a buy order at $35 hitsthe network and a sell order at $35 is present, youhave a match The order executes almost instanta-neously Because of their speed, ECNs are verypopular They now account for a large proportion

of daily stock trades I am sure this will continue toincrease in the future

ECNs were introduced in 1969 They provided away for institutions to display their buy and sellorders on the Nasdaq It was also the start of elec-tronically executed trades Prior to this, a Nasdaqtrader had no way of executing trades except viathe telephone ECNs sped up the process by hav-ing every trade executed electronically There is alot less handling, and transactions now occur infractions of a second instead of minutes All orders

on ECNs are firm orders This means the traderwho placed the order does not have the choice ofaccepting or declining a matching order As soon

as a matching order arrives into the network, thetrade is executed In a fast market, this feature ispriceless It allows traders to get in and out of theirpositions quickly

In 1996, the introduction of a new ECN calledIsland (ISLD) allowed small traders like you and

me to access the Nasdaq directly Prior to ISLD,the ability to buy and sell directly in the Nasdaqmarket was available only to large institutions.Since then, many new ECNs have been estab-lished Island and Instinet joined forces tobecome INET Brut is the Nasdaq’s ECN ARCA,

as mentioned earlier, has merged with the NYSE.Changes and consolidation will continue (Note:

As of this writing the Nasdaq is awaiting tory approval of its proposed acquisition ofINET.)

regula-How ECNs Work

As mentioned earlier, ECNs function as regionalexchange floors They have their own individ-ual markets and allow traders to trade directlywith each other ECNs accept both trader (indi-vidual) and broker (institution) orders Do notautomatically assume an ECN order to be from

a trader like you and me It could be a marketmaker trying to hide his or her true identity andintentions

ECNs do not provide capital to facilitate trades.They serve only as a conduit or intermediary to themarket They give the trader a medium for orderplacement and execution They compete directlywith market makers for order flow They have novested interest in the price of a stock They nowaccount for a very large proportion of Nasdaq’stotal daily volume

Traders enter bids and offers on a national tem that is visible worldwide Real-time visibilityand volume equal liquidity That’s why traders getfast results

sys-The three main ECNs available to daytraders are:

●1 Inet (INET)

●2 Brut (formally owned by SunGard Data and now owned

by Nasdaq Stock Market, Inc.)

●3 Archipelago (ARCA), which recently merged with the NYSEOther ECNs, playing smaller roles, include:

THEBIGBOARD ANDNASDAQ 23

QUICK QUIZ

Test your knowledge of the investment marketplace by taking the quick quiz that follows

The most famous stock exchange is the NYSE

Securities sold on the Big Board are called:

(a) M1-6(b) Listed securities(c) VIP securities(d) All of the above(e) None of the above

Nasdaq:

(a) Is market maker territory(b) Requires high-tech equipment(c) Is made up of stocks in the OTC market(d) All of the above

(e) A and B only

Which of the following statements are trueregarding market makers and their responsibilities?

(a) They fulfill their firm’s customer order flow(b) They have limited resources and do not do muchtrading

(c) They are required to keep a two-sided (bid andoffer) market at all times

(d) All of the above(e) A and C only

A specialist is:

(a) An assassin for the CIA(b) A market maker who specializes in trading one stock(c) An individual who is assigned a listed security on anexchange

(d) Somebody who knows a lot of secret stuff(e) A and D only

Which statements about the OTC market arecorrect?

(a) The OTC market is a negotiated marketplace(b) You can buy OTC securities at Kmart during theblue-light special

(c) It employs stealth Ninjas to eliminate opponents(d) OTC stocks come with a money-back guarantee

Which of the following statements are true concerning market makers?

(a) They execute trades for their firm’s customers(b) They have many different customers

(c) They are nice people(d) Nasdaq’s Level II displays market makers’ quotes(e) A, B, and D only

Which of the following types of market makersare considered to be the most powerful?

(a) Wholesale firms like Sherwood(b) Wire houses like Paine Webber(c) Institutional firms like Goldman Sachs(d) Investment banks like Montgomery

Which of the following are not market makers’

responsibilities (and which one is a trick)?(a) To keep an orderly, two-sided market(b) To trade for the firm’s proprietary account(c) To instigate program trading when markets drop toolow or rise too high

(d) To never quote both a bid and an offer on the samestock at the same time

(e) To advertise as a seller when they are really buyers

of a specific stock

Full-Service Brokers

These are traditional, established brokeragehouses They cater to people who do not have thetime to research stocks or follow the market Theyusually have research departments that makestock recommendations They also provide finan-cial and portfolio planning services This personalattention means high fees

Many brokerages provide clients with onlineaccess to their accounts But they do not providehigh-speed executions These brokerages are bestfor people who invest rather than trade

One word of caution: Full-service brokeragesclaim to have great research departments that willfind good stocks for you Based on my experienceworking for a brokerage, I would not put my trust

in them The people you deal with are merelysales representatives They want to make salesand collect commissions They are looking after

their interests, not yours It takes effort to find a

broker who truly has your well-being in mind Ithink this effort could be better spent learninghow to day trade If you don’t have the time to

trade, then buy an index fund and consistentlyput money into it In the long run, this strategywill probably pay more than investing in individ-ual stocks

Discount Brokers

These brokers provide automated systems thattake orders through the Internet They also takeorders over the phone Because there is less han-dling involved, they charge lower commissionsthan full-service brokers

Brokers like Charles Schwab, Quick & Reilly,Fidelity, TD Waterhouse, Scott Trade, and othershave e-trading services Customers can log on totheir account through the Internet and place buyand sell orders

Discount brokers also allow you to tradethrough a touch-tone telephone This comes inhandy when the Internet crashes Generally, com-missions range from $7 to $20 per trade These bro-kerages do not offer buy or sell recommendations.Instead, they give you access to research materialand allow you to make your own decisions

SELECTING A BROKERAGE

I F YOU HAVE THE MONEY AND THE TIME to trade, and if you are

willing to learn this profession, it’s time to select a brokerage house You will use the facilities provided by the brokerage to make your trades There are several types of brokerages They have the following characteris- tics and features.

BROKERAGEFIRMS 27

Direct Access Brokers

With the establishment of ECNs came a new breed

of brokerage firms called direct access brokers

Several large brokerages (e.g., Charles Schwab,Goldman Sachs, and Datek) now have divisionsthat provide direct access to the Nasdaq and theother exchanges Direct access is the fastest way toexecute a trade on both Nasdaq and the NYSE

There are no intermediaries involved Customersare responsible for routing their own orders to getthe best possible price Real-time charting andsoftware for technical analysis usually come withthe firm’s trading platform Commissions canrange from $5 to $25 per trade or may be on a per-share basis for under half a penny a share depend-ing on the volume of your trades and the firm youuse This is the only type of brokerage I would use

to day trade

EXECUTION SPEED

Execution speed is the most important tion when choosing a direct access broker High-speed execution allows you to quickly get into andout of positions This gives you control of yourtrading Please note, however, that not all directaccess brokerages are alike Execution speeds varyfrom firm to firm

considera-You need to search for the broker with the latest,fastest, and most reliable equipment A delay of acouple of seconds or a breakdown can cost youmoney I can’t give you an up-to-date list of thefastest and most reliable brokers Trading technol-ogy is constantly changing, so a fast system today

will be outmoded tomorrow As a rule, I wouldexpect a direct access broker to consistently exe-cute trades within two seconds or less For a dis-count brokerage, executions as long as 10 secondsare too long

Direct access trading means you are responsiblefor routing orders properly It is not as simple asclicking a buy or a sell order Unless you knowwhat you are doing, direct access trading can bemore of a hindrance than a tool Make sure youunderstand how orders are routed before tradingwith real money Some direct access platformshave smart order routing whereby the softwarechooses the fastest route Some will even let youset your preference of where the program shouldlook first

RELIABILITY

Fast execution is useless if the brokerage’s tradingsystem is unreliable Some firms use software thathas not been debugged This might cause a systemcrash when a large number of orders are placed atthe same time Bad software could also cause con-stant Internet disconnects, forcing you to keep log-ging back on If the firm’s software does notinteract properly with your computer, the systemmay constantly hang up your computer, forcingyou to reboot, a waste of valuable trading time.Browse trade journals and magazines to findevaluations of the various brokerages’ reliability.Talk to other traders; most traders have used sev-eral different platforms and will give you an hon-est opinion on which is best

Sometimes the problem is your computer Youcould be asking your ISP connection to downloadmore information than it can handle Your com-puter will freeze when this happens It is yourresponsibility to know the limits of your computersystem Today, a telephone-line modem isn’t suit-able for trading except as backup to a cablemodem, DSL, or other broadband connections Youmay need to buy a new computer to get the speedand performance you need for trading If you areusing a system with dual processors, check to see ifthe trading platform you use supports them Com-puter memory is inexpensive today, so maximize it.

ORDER ROUTING

Here are some questions to ask your broker beforeopening an account: Do you execute your ownorders or go through an intermediary? Do you sellorders through that intermediary? Can I get priceimprovement on my orders? Does the platformhave smart routing? Does it support multiplemonitor setups?

Brokers who execute their own orders tend tohave faster executions Brokers who sell theirorders to intermediaries add precious seconds tothe execution time The intermediary profits bytrading against your order Fills are poor and priceimprovements are rare Whatever price improve-ment the intermediary gets, the intermediarykeeps The easiest way to know whether a broker-age sells orders is to look at its financial statement

If its revenue stream includes an item called ments for order flow,” it is selling its orders

When you trade with a direct access brokerage,

it is important to know the following: Does thebroker allow you to route an order to an ECN such

as INET or ARCA? How many ECNs is it directlyconnected to? Does your direct access broker have

a straight connection to Nasdaq, or does the orderhave to hop through several offices before it gets toNasdaq?

If you trade heavily, good order routing cansave money You want as little delay as possiblebetween you and the market A good direct accessbroker will have a direct connection to severalECNs ECNs tend to execute orders a lot quickerthan market makers The more ECNs you havedirect access to, the more choices you have to getyour orders filled The more choices you have, thebetter your fills will be At the very minimum, abrokerage should have direct access to at least theARCA, INET, and BRUT ECNs, and preferably allthe available ECNs should be available to you.The best way to find out whether a direct accessbroker has efficient order routing is to send a liveorder to the Nasdaq Usually, I send the order on aslow-moving stock and place it away from theinside prices The order should show up at theNasdaq in less than two seconds Many firms takeeight seconds or more to get an order to Nasdaq.Make sure you avoid these firms like the plague.Order routing is getting faster and faster Cyber-Trader of Austin, Texas, a subsidiary of TheCharles Schwab Corporation, offers smart ordersusing its proprietary CyberExchange order rout-ing system It electronically routes orders to thetrading venue that offers the best price and best fill

BROKERAGEFIRMS 29

speeds These are often ECNs, which not onlyeliminate payment for order flow intermediaries,but also frequently avoid market makers them-selves

CyberTrader isn’t alone TradeStation, RealTickand E*Trade all offer smart executions Othershave a policy of not accepting order payments

Services are improving every year and brokers areconstantly merging The similarities between full-service brokers, Internet brokers, informationservice providers, and ECNs are becoming moreapparent Each tries to offer something unique

PRICE

Price is not as important as speed, reliability, andorder routing It is more important to get a fast exe-cution than low commissions A good executionwill ultimately save more money than a poor one

I had the following experience with one of mystudents He had worked for a firm with a cheapcommission rate I went to his home with my lap-top I hooked up to a 56-kilobyte modem line andprepared to trade He used the firm with the cheaprate I used a slightly more expensive firm withfaster executions After searching for a while, wefinally found a good opportunity

At my signal, both of us started placing orders

Our plan was to chase the entry by no more than

$0.25 If the stock moved past our entry by $0.25,

we would cancel our orders I bought 3,000 shares

of the stock, while my student ended up with ing The position moved about $1.50 in my favor,making some nice money for me The student

noth-saved $10 in commissions, but missed an nity to make $1.50 a share The worst part was themissed opportunity

opportu-We do not see a lot of good trading ties each day It is imperative that we have thetools to capitalize on those that we see That is whycheap commissions are not necessarily cheap.They usually cost you money in the long run.There are two ways commissions are calculated

opportuni-in this opportuni-industry The first method is per ticket A buyorder is one ticket A sell order is another ticket Atrade will generally cost you at least two tickets.Commissions can range from $5 to $20 per ticket,depending on the brokerage

In the second method, commissions are figured

on a per-share basis Depending on your tradingvolume, per-share commissions can range from

$0.005 to $0.02 a share If you buy 200 shares andyour per-share commission is $0.02, your commis-sion will be $4.00 Don’t forget that you also pay acommission when you sell Many companies thatcharge a per-share commission also have a mini-mum charge Some firms, such as CyberTrader,will let you choose either a per-share or per-tradecommission

Commissions can add up to hundreds or eventhousands of dollars every month for activetraders A balance has to be struck between cheapcommissions and execution speed There are otherbrokerage costs involved when trading You reallyneed to read the fine print For example, there may

be a per-share charge for each share exceeding1,000 shares if you are on a per-ticket commission.Some brokerages charge a small fee for cancel,

limit, and stop orders Manually assisted tradesusually cost more than electronic trades.

Direct access brokers have varying costs forreal-time quotes Some direct access brokers tack

on additional ECN fees They charge a low ticket fee, but have costlier ECN fees Their inten-tion is to draw you in with the low per-ticket feeand profit from the higher ECN fees

per-Make sure you evaluate the whole commission ture Do not just focus on one area.

struc-SERVICE

If you trade from home and experience a computercrash or a lost Internet connection, your brokerageshould come to the rescue without much delay

Here’s what you should expect in the form ofbackup help: You should be able to call a represen-tative and execute the trade “by hand.” A goodonline broker will reduce the price of the trade ifthe problem occurred with the brokerage The rep-resentative should not take more than a few min-utes to answer your call

A good online brokerage should have a toll-freeservice desk that can answer any technical ques-tion Even in this day and age, there will beglitches The last thing I want to do is become acomputer expert just so I can trade I leave that tothe technical support team of the brokerage Somebrokers offer online support directly from the plat-form using “text chat.” If the support team isunable to solve the problem, they might want tolog on to your computer remotely and have a lookaround Check to see if that feature is available

OTHER ONLINE BROKERAGE FEATURES

Other features you might consider when selecting

a brokerage service include the following:

Products available for trading Never assume a

broker-age has the product you want to trade Brokerbroker-ages thatspecialize in equities might not have futures and com-modities Many equity brokerages don’t offer optionstrading

Quote services Delayed quotes are free; real-time

quotes are not Real-time quotes make all the difference

in a market that changes by the minute Find out whichbrokers offer real-time quotes and how much they charge.You also want to know if Level II access is available and itscost

Charts Many brokers provide charts or links to charts.

Find out whether the charts are interactive and whetheryou can set the parameters Also, find out whether thecharts are current, whether they load quickly, and whetherthey are real-time or 15-minute-delayed

News and research services Some brokerages provide

real-time newswire services Others provide news at theirwebsite Some brokerages provide extensive researchdatabases, while others do not

TYPES OF ACCOUNTS

There are several types of brokerage accounts youcan use to day trade You can open a corporateaccount, a partnership account, a retirementaccount, or just a personal account Most tradersuse a personal account for simplicity, but once youstart making money, trading under a corporation

BROKERAGEFIRMS 31

or retirement account does have tax benefits sult with your tax advisors before you decide onone or the other

Con-There are two major types of trading accounts:

margin accounts and cash accounts.

Margin Accounts

A margin account is a leveraged account The kerage lends the account owner part of the pur-chase price of a security The collateral used for theloan is the stock itself; no credit check is necessary

bro-Some securities are not marginable A securitypriced below $5 is a good example Because theytend to be high-risk issues, brokerages are unwill-ing to use the stock as collateral

You must understand two concepts when using

a margin account: the buying power level and the

margin maintenance requirement Buying power is

the maximum dollar amount of stocks you can

purchase on a given day The maintenance margin is

the amount of cash you must have in your account

to continue to hold a position

If an account is not being used for day trading

or pattern trading, the buying power level is two

to one If you have $10,000 in the account, you can buy up to $20,000 of marginable stocks Thismeans you can borrow up to 100 percent of thecash in the account If the maintenance level is 30percent of the value of the stock, you will need

$6,000 in cash to keep the $20,000 position

If the value of the stock drops, and the cash inthe account drops below the maintenance level,the owner will be asked to put in more cash or sell

a portion of the stock This is a margin call In other

words, someone will call you because your margin

is insufficient This is not a call I like to receive.Here’s an example of how a margin call couldoccur: You buy 100 shares of a $200 stock usingyour margin account The price drops from $200 to

$150 This is a $50 loss per share and a $5,000 loss

of capital The account now has $5,000 left ($10,000original capital −$5,000 loss), and the total stockvalue is $15,000 ($150 × 100 shares) The mainte-nance margin is $4,500 ($15,000 × 30%) At thispoint, the capital is still higher than the mainte-nance margin, so a margin call will not be gener-ated Any further drop in the price of the stock willtrigger a call

The buying power for a day trading account iseven greater New regulations allow a four-to-onemargin on day trading accounts The trader musthave a minimum balance of $25,000 in the account.The maintenance margin requirement on the newfour-to-one margin rule has not changed A daytrader who uses up his or her buying power anddoes not sell stock to generate cash will get a mar-gin call This is because the maintenance margin is

at 30 percent, while the capital available is only 25percent of the buying power

How does the SEC define a day trader or tern trader? The SEC defines a day trade as a pur-chase and sale or sale and purchase of the samesecurity on the same day in the same account Ifyou go long on a position and close it the same day

pat-or go shpat-ort on a position and close it the same day,you are day trading A day trader must trade atleast four times in five business days However, ifthis trading does not exceed 6 percent of the total

trading activity for a five-day period, the account

is not considered a day trading account

A margin account is needed if you want to shortstocks (Shorting is explained in the next section.)

A trader who fits the definition of a day tradermust have $25,000 minimum equity in his or heraccount to day trade

Cash Accounts

In a cash account, your capital equals your ing power Cash accounts are mostly used bylong-term investors Retirement accounts are cashaccounts If you want to day trade, make sure you

buy-do not have a cash account

Certain trading products, because they are sidered risky, must be traded in a cash account

con-Options transactions are a good example con-Optionsare extremely risky Unlike stocks, they have noinherent value Options are only a right to buy or

to sell The owner of an option does not own thing except that right Options are not worthmuch as collateral Brokerages are thereforeunwilling to extend margin against these holdings

any-TYPES OF POSITIONS

There are two types of positions that a trader can

have They are the long position and the short

posi-tion The market allows traders to profit in eitherdirection of the market When the market heads

up, a trader can go long on a position and profitfrom it The trader buys the stock, holds it, andsells it later at a higher price Thus, traders are to

be long on a position if they own the stock Their

profit comes from buying the stock at a low priceand selling it at a higher price Losses occur whenthe selling price is lower than the purchase price.When the market heads down, traders can makemoney by going short A trader sells the stock at ahigh price and later buys it back at a lower price.The profits and losses are no different than a longposition Losses come from paying more for thestock than the original sale price

The only difference between the two positions

is the timing sequence On a long position, thetrader buys the stock first and sells later With ashort position, the trader sells the stock first andbuys it back later

Most newcomers have a hard time grasping theconcept of shorting They wonder how it is possi-ble to sell something you do not own The key tomaking this possible is the intermediary: your bro-kerage

To sell something they do not own, traders dothe following: After borrowing the stock, they sellthe stock, getting cash in return But they still owe adebt to the brokerage The debt is not in the form ofcash It’s in the form of the shares they borrowed.The only way a trader can repay this debt is to buythe shares and give them back to the brokerage It isonly after the debt is repaid that a profit is realized

To clarify this concept, here’s an example of asuccessful short trade: You are a trader You thinkIBM, currently trading at $125, is going to fall Youborrow 100 shares from your brokerage You sellthe stock immediately, getting cash in return Youstill must return the 100 shares you borrowed Youwill do this after the price falls

BROKERAGEFIRMS 33

When you sold the stock you borrowed it waspriced at $125 per share Thus, you received

$12,500 in cash Remember, you think IBM is going

to fall You do not return the shares to the age right away You let it fall When it hits $100,you buy 100 shares so you can return them Youhave already sold 100 shares at $125, getting

broker-$12,500 Now you buy 100 shares at $100, ing $10,000 Remember, you sold 100 shares for

spend-$12,500 Then you bought 100 shares for $10,000and returned them to the lender You keep the dif-ference of $2,500 Buying the shares to return them

is called covering your short.

To short successfully, you borrow shares, sellthem at a high price, and then buy them back at alower price It is sell first, buy later As a trader, short-ing has to be part of your strategy If it is not, you willseverely limit your moneymaking potential

Shorting Guidelines

Here are the regulations for shorting Short sales

can occur only on an uptick The Nasdaq and the

stock exchanges define uptick in different terms

For exchanges like the NYSE, an uptick isdefined by the time and sales or the last trans-acted price If the last price is higher than theprevious one, then you have an uptick on thestock For the Nasdaq, the uptick is determined

by the inside bid price If the current inside bidprice is higher than the previous inside bid price,then you have an uptick In both cases, shortsales can happen only when the stock price is ris-ing, even if just briefly This is a safety measure

to prevent another stock crash like the one in

1987 If stocks could be shorted as they fall, chaoswould follow

In order to short a stock, it must be available forborrowing from your brokerage firm or clearing-house Stocks that are thinly traded are usually notavailable for selling short This happens becausethe brokerage cannot obtain the stocks you want toshort Another problem might arise after you short

a stock As you know, in order to facilitate a shortsale, the brokerage must first borrow and thenlend you the securities that you sell short

From time to time, a brokerage will receive arecall notice on the shares it lent to you If the bro-kerage is unable to obtain replacement shares tosecure your position, it will sell the short position

in your account on the open market at the currentmarket price As the account holder, you will beresponsible for any resulting loss or costs incurred

by the brokerage

A short sale is always handled as a margintransaction Shorting involves borrowing stocks,and only margin account holders are allowed toborrow The current margin interest rate is appliedfor however long the short position is open.The margin maintenance requirement is a littlehigher for selling short than it is for a long posi-tion Often, brokers will not charge margin interest

on short trades that are opened and closed thesame day New issues typically cannot be shortedduring their first 30 days of trading

Please note, as of this writing the SEC is proposing

to remove the uptick rule Presently, you can short

on a downtick on ARCA and INET ECNs, and boththe Nasdaq and NYSE are testing feasibility on a

limited list of stocks Check with your broker for thelatest rules and regulations.

Dangers of Short Selling

A widely perceived misconception is that shortingcan lead to disaster This is true, but only if you let

it be true When you buy a stock, you risk themoney you paid for the stock With short selling,you risk an unlimited amount of money If thestock you shorted rises instead of dropping, youwill be responsible for that increase in price Thiscan indeed lead to a disastrous loss

But again, this will happen only if you let it pen Nothing should stop you from quickly clos-ing a short position if it goes bad Many shorttraders do not have an exit plan An exit planmeans setting an exit point If you short a stock at

hap-$35, plan to get out of the position if it rises to a tain point, say $36 Do not attempt shorting with-out an exit strategy

cer-TYPES OF TRADING ORDERS

A day trader has a variety of trading orders tochoose from Two factors determine which type oforder should be used: timing and price Timing isthe length of time an order is left open You canleave an order open briefly for a day or longer

The Market Order

The simplest form of order is the market order It is

an order that must be executed at the best priceavailable as soon as the order reaches the marketmaker or trading floor No price is specified Thetransaction has to be made at the current market

price I use market orders to get out of losing tions When a stock hits my stop-loss, I get outimmediately at the market price If I wait, I couldlose even more I also use market orders at thebeginning of an up move If an uptrending stockhas made a nice pullback and is beginning to turn

posi-up, I use a market order to catch a ride on theupswing

Market orders are susceptible to slippage Let’ssay the stock is moving up after a pullback This is

a buying opportunity But a lot of buyers will jumpinto the stock Because demand for the stock ishigh, the price will move up quickly You will getfilled because you have entered a market order.But the price will be higher than you thought This

is called slippage, and it applies to both winning

and losing trades When you want to take a profit

on a winning trade, others will be doing the same.When you want to get out of a losing trade, othertraders will have the same objective The key is toenter your market orders early Never wait or hes-itate If not, the slippage can be extreme

A market order is good for the duration of thetrading day An order placed after the close of trad-ing is good for the next trading day It’s a simplesystem that works well Never deal with a firmthat takes too long to fill a market order It could betrading against your order, putting you on the los-ing end of the trade Market orders should be filledwithin one or two minutes

The Limit Order

A limit order guarantees a price You literally place

a limit on the buy or sell price If a better price thanyour limit price is available, you’ll get that price

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As you will see next, limit orders do not tee that your trade will be executed

guaran-The Buy Limit Order

This is an order to buy shares at a stipulated price

The limit price can be higher or lower than the rent market price I use buy limit orders to takeadvantage of pullbacks If a stock currently at $35

cur-is dropping, I place a buy limit order lower thanthat price When the stock hits the lower price, theorder is executed Computerized order books sendthese orders to specialists and market makers, orthey are executed automatically on the ECN If theprice you set is not reached, there is no execution

I also use this strategy when I am exiting a shortposition I place a below-the-market order andwait for the price to drop far enough to buy backthe shares I shorted Again, you should place theorder early Do not hesitate

I also place buy limit orders at a market price when I am opening a position Here’s

higher-than-an example of this strategy: A stock is trading at

$35 I expect the stock to run to $36, giving me aprofit of $1 I send a buy limit order at $35.25 Theorder will be filled only at $35.25 or lower If theprice goes above $35.25, my order will not befilled This keeps me from paying too much, andthus I make a small profit If the stock runs upquickly, I will cancel the order and wait for a pull-back

The Sell or Short Limit Order

Sell or short limit orders are similar to buy limitorders But they set a sell or short price targetinstead of a buy price target Again, the limit price

can be either higher or lower than the market If Ihave a long position and the stock is climbing, Iplace a limit order to sell at a price higher than themarket Once the price hits my limit price, theorder will be executed I do not like placing limitorders to exit a losing position if it is higher thanthe market price They tend not to get executed,leaving me worse off than if I had simply placed amarket sell order to get out

I use limit orders when I enter a short position.This prevents me from getting into a stock at theend of a run, leaving me with little or no profit Mylimit price is determined by how much profit Iexpected, but I tend to limit my price to $0.25 awayfrom my entry point Don’t forget, you can alsoshort using a limit order that is higher than themarket price You are simply waiting for the price

to bounce up to a resistance point before enteringyour short position

mar-The Buy Stop Order

A buy stop is a buy order that becomes an activemarket order only when the stock rises to a specified