Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
3 Contributors
4 Web Watch
6 Getting Connected
What’s the best way to “plug in” — modem, dial-up, DSL, cable?
Here’s how to set up your communications for maximum efficiency.
19 A Matter of Timing
Combining analysis on different time frames — intraday, daily, weekly — gives you an
edge. Here’s a unique approach that incorporates multiple time frame indicators
on a single chart.
Trading is a business. who will give you both fresh insights on different trading
approaches and a feel for how your industry is developing.
Trading hardware and software: Your computer setup, com-
The Internet has indeed revolutionized the trading process, munications and software are an integral part of your trading.
but taking profits out of the market is still the same game it was We’ll keep you abreast of the latest trading technology and how
when price quotes were disseminated via giant chalkboards on to make the most of it. In this issue, Gibbons Burke compares
financial exchange floors. Trading is, and always will be, about the different Internet connection methods and uncovers a new
understanding the market, having an edge and executing a option that can decrease your risk of getting blown off the ‘Net
plan. When information overload is an increasingly real hazard in the middle of a trade.
for traders, it’s more important than ever to focus on the best Risk control: Rather than simply pay lip service to the sub-
trading resources available. ject, every month we’ll devote an article to risk control and
So, read any good trading magazines lately? money management — specific ideas to help you control losses
Active Trader is based on a very simple concept: Trading is a and maximize your profitability. This month, for example,
business. It’s not a pastime, it’s not a hobby. It’s a profession, Thomas Stridsman explains why a popular stop approach does-
one that should be approached like any other — with clear n’t work and then illustrates a technique to keep your risk at the
goals and a realistic attitude. same level on all your trades.
Our goal is to provide you with the best trading information Trading as a business: Finally, our monthly “The Business of
possible — the tools you need to become a successful trader. Trading” column will give you the bottom line on taxes, legal
We’ll do the research you wish you had the time to do and give issues and other little-discussed aspects of trading that can
you the bottom line on the trading strategies, key industry news, mean the difference between actually keeping the majority of
latest Web sites, books and software, and tax and legal issues that your hard-earned profits and watching them disappear every
impact you the most as a short-term trader. Our coverage will April 15. Do you have trader status? Do you even know what
encompass stocks, options, currencies and futures, with material trader status is? Reading CPA/trader Ted Tesser’s article on p.
for the market novice as well as the seasoned professional. 88 could be one the best moves you make this year.
What we won’t give you is hype about “can’t-lose” trading Good traders know the value of good research — it’s the
systems, tales of overnight riches or incomprehensible jargon. foundation of every solid trading plan. That’s what Active Trader
We won’t sugarcoat the risks or downplay the hard work. is all about. Think of us as a low-risk opportunity with unlimit-
Flip through these pages and you’ll get an idea of where we’ll ed upside potential.
be taking you in the months and years to come. The following In other words, a good trade.
list is only the tip of the iceberg.
News: We don’t have the most recent three-year forecast from
the economic think tank, but we do explore the proposed
changes to minimum account equity and margins, as well as
developments in the electronic trading arena that could directly
affect the way you trade each day.
Trading strategies: If you’ve only thumbed through a few Mark Etzkorn, Editor-in-chief
The trading EDGE The site is broken down into six sub-sites: Daily, Courses,
Tactics, Wizards, Resources and Systems. Courses is merely an
advertisement for HRE’s trading system, but the other five
I
deserve a closer look.
f you’re looking for a thorough, comprehensive and Daily lists stocks whose price
downright helpful Web site, Hard Right Edge (HRE) charts suggest a sharp move
— www.hardrightedge.com — should be your next stop on could be imminent, or ones that
the Web. It has a plethora of information for the active trad- fall into categories like Dip Trip,
er, from the basics (price charts, suggested reading) to the Power Spike and Finger Finder
advanced (Bollinger bands, Fibonacci charts). And it’s free. (yes, these concepts are explain-
ed). Links are plentiful on this
page and pretty basic, connecting
T
backs, splits), among others.
he Fly on the Wall (www.theflyonthewall.com) doesn’t attempt to Tactics is just that — strategies broken
inundate visitors with detailed analysis or in-depth discussion. down into eight sections (bottoms, break-
Instead, this subscription-based delivers quick-hit information on stocks mak- outs, corrections, day trading, indicators,
ing news. Cost: $49.99/month or $39.99/month paid a year in advance (two- market quirks, new highs and tops). With
week free trial for visitors). 38 different terms explained (our favorites
are fun with Fibonacci and hell’s triangle),
Fly’s goal seems to be to give you an idea of which stocks might be hoppin’
the newbie could spend days here and
based on the latest word from Street insiders. Upgrades and downgrades,
even the experienced trader might find a
earnings reports, conference calls, splits — they’re all chronicled on the news
new nugget of knowledge.
“ticker” (it’s not streaming text, but it does update automatically) that stays
at the top of the page, no matter what part of Fly you visit (you can set it up Wizards picks the brains of various
so that the ticker stays with you no matter where you go on the Web). trading gurus (including Mark Seleznov,
The ticker is broken down into seven categories: hot stocks, general news, who contributed “Playing the break(out)”
rumors, recommendations, pre-opening news, conferences/meetings and syn- for this month’s issue).
dicate. Resources lists numerous books that
Clicking on an item in the ticker accomplishes two things: First, it brings up might be of service to the short-term
a pop-up box showing all stocks that have similar news (i.e., if you click on an trader and has links to magazine articles
item about a company being upgraded, you’ll get a list of all companies that and other helpful items on the Web. In
fall under the “recommendation” category). Also, it will take you to that addition it features a complete glossary
company’s main page on Fly, where every tidbit of information that has come of technical terms and topics, and gives
across the ticker is listed for easy viewing. On the main page, there’s also in-depth information on dozens of indi-
access to a stock chart that can be configured many different ways (perhaps cators, patterns, systems and market con-
Fly’s best feature). cepts. When HRE says resources, it
means resources.
First-time visitors to Fly may find things a bit confusing. There’s a help link
on the top of every page, but we pretty much just clicked our way around Systems focuses on the hardware nec-
until we got a better feel for the site. And, we noticed one strange thing: The essary for online trading. Hard drives,
“rumors” section of the ticker was usually blank or filled with a minimum monitors, memory and storage are dis-
number of items. Perhaps that fly has a hearing problem. cussed in detail, with (of course) plenty
Fly will e-mail you alerts when news comes in on a company you’re follow- of links to choose from. Ý
ing, and its cross-referencing options are plentiful. Ý
GET smart
Getting connected
Your trading setup starts
with your Internet connection — it’s your lifeline
to the market. Get the bottom line on the different
communication technologies and how you can
not only get connected but stay connected —
when it counts most.
can be disaster when you’re in the mid- per second (bps) using Plain Old
dle of a trade. Telephone Service (POTS).
The active trader has many available Over the years, technological
BY GIBBONS BURKE options to connect to the World Wide advances allowed the bps rate to steadi-
Web and all the information it provides. ly increase, up to the 56,000 bps modems
However, there are some key considera- in use today. Considering telephones
tions in making a selection: provide analog transmission, 56K is
Speed: How much bandwidth do you probably the upper limit for modems. In
W
need? fact, with the limitations of analog, the
Reliability: Your Internet connection maximum speed of a telephone connec-
is your trading lifeline — can you trust tion can’t even reach 56K, no matter
hen trading first swept it? what modem manufacturers would like
the country in the early Cost: You can’t be penny-wise and you to think.
part of the 20th century, dollar-foolish. While cost is a factor, When your computer dials up another
the only way to get a active traders must weigh it against the modem — say, for example, your
stock quote was through your broker’s amount of money they regularly put at Internet Service Provider (ISP) — the
office. risk. Saving money and choosing an two engage in a “hand-shaking” ritual
The broker had a direct connection to inferior Internet connection can result in where they test the quality of the con-
the exchange and a “ticker” device large trading losses. nection. When your computer makes
would spit out quotes onto a thin sheet The most important thing to remem- those crazy, screeching noises while con-
of paper — the ticker tape. One person ber is that getting connected is one thing, necting, that’s what is happening.
would stand at the ticker and shout out staying connected is another. The two modems often speak different
quotes, while another person would dialects, so a peak data transfer rate is
write down the quotes on a chalkboard not always achieved. Furthermore, ISP
for everyone in the office to see. The Internet is a relatively new method connections are often digital, so the ana-
For decades this system remained of communicating. If you choose to rely log-to-digital connection makes it diffi-
essentially unchanged. on it for trade entry and market informa- cult for maximum speed to be achieved.
Eventually, the ticker box and chalk- tion, you must be prepared to deal with Certain companies (AltaVista,
boards were replaced by electric dis- the problems that can occur. With some NetZero) offer free Internet service,
plays, but the broker’s office was still the planning and precaution, you can take although these systems will log you off if
only place to get quotes. steps that minimize the risk of your trad- you don’t do anything on your computer
Today, the Internet allows online ing being interrupted. for 20 minutes, so they’re probably not
traders to get instant quotes, research The first step in the process is getting a suited for trading.
reports, company news and financial fil- connection. You have five basic choices: The standard rate is between $19.95-
ings — not to mention place trades — analog telephone dial-up (modem), digi- $21.95 per month for unlimited access —
anytime. Because “trading” is quickly tal telephone (ISDN, xDSL), digital cable, sometimes lower if you sign up for a
becoming synonymous with “online wireless, and hybrid solutions (Web year’s service ahead of time.
trading,” your Internet connection is a ramp). Bottom line: Dial-up service is most
fundamental component of your trading useful for two reasons. First, it is the eas-
setup. Lost seconds or, God forbid, min- iest to use. Modems are commonplace
utes because of a communication failure Telephone modems have been around are relatively inexpensive.
may not mean much if you’re browsing for a long time. The very first ones could Second, it is transportable. You can dial
the Web for tuna casserole recipes, but it send and receive information at 110 bits into your ISP from just about anywhere
S omeone once said, “Diversification is the only free lunch on Wall Street.”
What he meant was that the best way to reduce your risk exposure was to
how this connectivity functions.
Ramp Networks, Inc. (www.web-
ramp.com) manufactures the routers
diversify your investment portfolio among a number of stocks. The same logic can that allow you to pool bandwidth. The
be applied to the information and execution risk in your trading. company’s Web ramp black boxes also
If you have only one way to get connected to the Internet — say through an ISP include an Ethernet hub with four jacks.
— and that ISP is having a bad day, your portfolio could have a bad day, too. Obviously, the more phone lines and
A trader should, at a bare minimum, have at least two ISP accounts. A backup ISPs you use, the higher the costs are
is necessary if the first one shows any sign of trouble. And even if your main ISP going to be. However, at $20 per month
seems OK, it may develop traffic snags. Having a second ISP ready to go should per ISP, it’s not prohibitive. And, addi-
allow you to find another route and bypass the traffic. tional phone lines are not that much
There are some useful tools for diagnosing Web traffic. Windows comes with more if you avoid all the extras (i.e., call
two of them: “ping” and “tracert.” waiting, call forwarding, three-way call-
Ping measures the time it takes for a message to travel from your PC to the ing) the phone company wants to sell
destination server. Tracert traces the route between your PC and the destination you. Considering what could happen if
server and lets you know how much there was at each “hop” along the route. you are frozen out from making a trade
Ping Plotter, a $15 shareware tool available at www.nessoft.com, combines the at a critical time, it’s money well spent.
function of ping and tracert into a visual display. It provides a dynamic trace route Bottom line: Web ramps are truly the
display that continually monitors connection quality. It allows you to instantly spot most robust way to connect to the
a traffic jam and even gives you the phone numbers of the network operators so Internet for trading, at least until the
you can let them know when there is a problem. Highly recommended. Internet itself is more robust. Ý
Maverick short-term trader Gary Smith, who has averaged $14,000 per month
in profits over the last three years, will choose D every time.
Find out how he takes consistent profits out of the stock market.
BY GARY SMITH Nasdaq 100 and Russell 2000 cash lates into being in sync with the rhythm
indices. of the market — and that rhythm is its
A year ago, in fact, I had to do just that momentum.
M
as I helped a friend move across country.
For an entire week, I did not have access
to CNBC, the World Wide Web or any of My trading methodology is based on
any traders look at me the financial publications I usually rely several short-term momentum patterns
with a skeptical eye on for information. I survived solely by that keep me attuned to the market’s
when I tell them how I making frequent phone calls to get rhythm. These are outlined below and
trade the stock market updates on my cash indices. But my followed by real-life trading examples
for a living. That’s because I’m totally trading did not suffer: I actively traded that show how they capture significant
opposed to perceptual filters like charts, and made $10,000. price moves.
oscillators, waves, cycles, moving aver- So, you may ask, how profitable has While these patterns are all short-term
ages, and all the other approaches and this simplistic trading style been over techniques, they can sometimes develop
systems traders typically use to under- the years? Starting with a $2,200 account into bigger trades. I trade all my momen-
stand price behavior. To add insult to in the spring of 1985, I have methodical- tum and divergence patterns with the
injury, I also believe all the glitzy com- ly parlayed my trading skills and capital expectation they will result in immediate
puter equipment and software so fre- in such a way that over the past three further strength (or weakness) over the
quently advertised for traders is unnec- years (ending December 1999), I’ve aver- next few trading days. If this price
essary. aged over $14,000 in monthly trading strength continues, so much the better.
BY MARK S E L E Z N O V
tern- or indicator-based, most successful with 50 percent winners and 50 percent
traders use a systematic plan to select losers, but the average win was $600 and
their trades. Even floor traders, who the average loss was $300. You would be
A
basically trade tick by tick, follow a sys- pretty happy, right? Unfortunately,
tematic approach. many inexperienced traders are uncom-
Short-term and day traders who make fortable with being wrong a large per-
hitter in baseball can fail 70 hundreds of trades a month have no centage of the time.
percent of the time but still room for faulty judgment or excessive There is no “holy grail” in trading.
make it to the all-star game if risk-taking. A trading plan helps guard The typical trader usually gravitates
he gets enough doubles, against these problems by taking the toward strategies with very high win-
triples and home runs with the other 30 emotion out of trading. ning percentages, but often falls prey to
percent of his at-bats. A successful trading plan does not “black box” systems that are limited to
It’s the same with trading. In fact, the have to be right all of the time, or even one stock or commodity. Many other
average successful floor trader is correct most of the time, to be profitable. It is the methods show results for limited time
only around 30 percent of the time. He slugging percentage that counts. If your spans, such as periods of great price
stays in business by practicing the old loss when “striking out” is small, but increases or bull markets. Good trading
cliché of “cutting losses short and letting your hits are big, you can be an overall strategies keep losses small, let profits
profits run.” And he does that by devel- winner. expand and work over long periods of
oping a sound, systematic trading plan. Think of it this way: Suppose you had time in different market conditions.
Regardless of whether they are pat- a method that triggered 30 trades a day Before detailing a specific systematic
44
TRADING EXAMPLES
43 1⁄ 2
Here are examples of the SBM8 system
at work:
43 Figure 1 shows MCI Worldcom
B (WCOM), which closed at 41 5⁄8 on
Friday, Jan. 28 and opened up the next
42 ⁄21
The SMB8 strategy triggered twice in the same day in Biogen (BGEN).
this trend, as buyers push the stock
higher. Here are its components: 2/01 G
94
Time frame: 10-minute bars, normal
trading hours.
Studies: None.
Setup: 92
1. The stock opens higher than the F
E
previous day’s close.
90
1
⁄8, triggering the trade at 87 11⁄16. At A
11:10 a.m., the stock slipped 1⁄8 below 88 D
the low of the previous two bars, and an
C
exit at 87 7⁄8 closed the trade with a B
gain of only 3⁄16 (C). 86
But immediately after this exit,
BGEN made four consecutive bars with
lower or equal highs. At noon (D), the
stock exceeded the previous bar (a bar 84
with a very tight range, less than 3⁄4)
by 1⁄8, at 87 7⁄8, triggering another
trade. BGEN rallied immediately, mov- 82
ing higher until 1:50 p.m., when the
stock traded 1⁄8 below the low of the
last two bars, signaling an exit at 14:00 15:00 10:00 11:00 12:00 13:00 14:00 15:00 16:00
91 1⁄16 (E), for a nice 3 3⁄16 gain on a risk Source: Trend Trader and Townsend Analytics
of 1⁄2 point.
Finally, late in the day BGEN went
into another setup pattern at 3 p.m. (F FIGURE 4 USA NETWORK (USAI), 10-MIN.
to G). However, the filter rule to not
trade after 3 p.m. keeps us out of the The bar before the entry bar must have a range of no more than 3⁄4, because
market. Still, not a bad trading day, risk on an SMB8 trade is limited to one point and the stop is placed 1⁄8 below
with two winners producing a 3 3⁄8- the low of the bar preceding the entry bar.
point profit. 55 2/02
In Figure 4 USA Networks (USAI)
gapped up from its Feb. 2 close of 541 ⁄2 D
49 15⁄16 to open at 519⁄16 (A) and then
sold off. After three bars of lower or 54
equal highs, the stock broke above the
previous bar by 1⁄8 at 10:20 a.m., trig- 531⁄2
gering entry at 50 7⁄8. The previous bar
had a 1⁄4-point range, giving the trade 53
a 1⁄2-point risk (B).
USAI ran for the next 90 minutes 52 1⁄2
before an exit signaled (at 11:50 a.m.)
at 515⁄8, for a gain of 1 1⁄16. (Although 52
this was a “wiggle stop,” one that just C
touches the exit point, you have to get 51 1⁄2 A
out — rules are rules.)
From 12:20 p.m. through 12:50 51
p.m., the stock made three lower or
equal highs, a congestion pattern that 50 1 ⁄2 B
qualifies under all of our rules (C). A
trade is triggered at 52 3⁄16, and with 50
the previous bar having a range of only
1
⁄8, the risk on this trade is only 3⁄8. 49 1 ⁄2
USAI rallied strongly until the exit rule 14:00 15:00 10:00 11:00 12:00 13:00 14:00 15:00
closed the position at 53 3⁄4 at 2:10
Source: Trend Trader and Townsend Analytics
p.m. with a 1 9⁄16-point gain (D).
A matter of timing
Analyzing multiple time frames is a simple but powerful yield good results if your analysis is
based on a solid frame of reference. Here
way to improve your trading. Here’s a technique that allows we will explain a simple, but powerful,
concept — multiple time-frame analysis
you to look at three different levels of price action on the
— and show how it will enhance your
same chart and time your trades accordingly. trading by providing a well-defined
framework in which to operate.
T
The basis of multiple time-frame analy-
rading is not necessarily easy, ing a few thousand miles to get to your sis is that every time period has its own
but it is a much simpler process back yard. trend and its own support and resistance
than most people imagine. The New traders especially tend to run levels.
problem, ironically, is that gain- into difficulties because they believe that By simple inspection, you can see the
ing this understanding often requires a more — indicators, charts, statistics, etc. trend and support and resistance levels
long, complicated journey — kind of like — is better. on a 10-minute bar chart are different
walking out your front door and travel- The truth is, simple approaches can than levels on a daily bar chart.
average of Friday closing prices plotted in step formation on the daily chart. It
shows the weekly trend overlaid on the daily price action. where
EMA1 is a longer-term exponential
moving average (e.g., 26 days), and
EMA2 is a shorter-term exponential
moving average (e.g., 5 days).
90-00
F Figure 3 is the same as Figure 2
except that the ECO (calculated on the
80-00
E 78-minute bars , the own time frame) is
plotted below the price series as a his-
70-00
togram. The ECO functions as a filter:
D Readings below zero confirm the trend
is down for the own time frame and
60-00 readings above zero confirm the trend is
up.
A
Weekly balance step Look at point G: The ECO actually
C 50-00 turned negative prior to the daily bal-
B ance step turning down. When the daily
balance step turned down at point H
40-00
(same as Figure 2), the ECO had been
negative for some time and therefore
30-00 confirmed this change in the trend of
10/01/99 11/01/99 12/01/99 01/03/00
the next time period.
Source: Fibonacci Trader When price rallied above the daily
balance step at point J, the ECO only ral-
lied above the zero line for one day, or
FIGURE 2 WEEKLY AND DAILY BALANCE STEPS five 78-minute bars, before returning to
a negative trend. After point J, the ECO
America Online (AOL), 78-minute. Here, the daily balance step is a five-day also reconfirmed the downtrend.
moving average of daily closing prices plotted in step formation. In addition, the
weekly balance step is shown. This makes it possible to simultaneously compare
price action on three different time frames.
Having outlined the concept of using a
multiple time frame approach to deter-
mine the trend and support and resist-
Daily ance levels, let’s see what happens if we
H balance step take a trade when the trend changes
Weekly
direction, as determined by a change in
balance step
the next time period (the daily balance
F step). We’ll use the intraday (78-minute
X bar) time frame.
E Now that we are trading, though, we
also must give thought to risk control:
D We will want to have some kind of trail-
ing stop to lock in our profits. For that
purpose we will introduce another indi-
cator, the HiLo Activator, based on the
own time period.
The HiLo Activator is a 21-period
moving average of the lows or highs. If
price closes above the HiLo Activator, the
indicator is a moving average of the lows;
when the market closes below the HiLo
12/13/99 12/20/99 12/27/99 01/03/00 01/10/00 01/18/00 Activator, the indicator flips to being a
Source: Fibonacci Trader moving average of the highs. The HiLo
BY M. ROGAN LABIER from where the market was when you Electronic Communication Networks
entered. (ECNs), the computer networks that
Live and learn, you think. Occasional offer trading of Nasdaq (and now, New
communication glitches are part of the York Stock Exchange) stocks — how
online trading environment, although they work (and don’t work) depending
C
this is the first time you have suffered on circumstances.
from such a severe problem. So you First, we will briefly explain the
onsider the following situation: swear off your dial-up modem connec- Nasdaq’s two order execution systems,
You’re sitting on a hard-earned tion and standard online broker and SelecNet and SOES (Small Order
profit toward the end of a chop- switch to a DSLconnection and a “direct Execution System). Depending on trad-
py trading day. Things haven’t access” broker. However, a few days into ing conditions, SelectNet and SOES have
been going well, so you’re especially trading with your new setup, virtually their own advantages and disadvan-
happy to find yourself ahead at this the same thing happens again. tages as trade execution systems. While
point in the game. You decide to close What is going on? the following explanations will be brief,
out your position and call it a day. You What you didn’t realize is that there a rudimentary understanding of these
enter your sell order and wait for confir- are many trade execution “routes” avail- systems will help to understand the way
mation. able to the Level II trader (see “Level II ECNs work.
And wait … and wait. trading,” p. 48) and all these routes work
Meanwhile, the market has started to differently from one another. It is not
tank and you are facing the prospect of enough to simply know these routes Unlike the NYSE, the Nasdaq does not
your profits disappearing before your exist — you must know exactly how have a trading floor where traders buy
eyes. After an eternity (or so it seems), they work to be able to trade effectively. and sell stocks face to face. On the
you get your fill — five points away We’ll explore the ins and outs of Nasdaq, trades are executed over a net-
T
long as another trade has not already here are three “levels” of quotes available to Nasdaq market partici-
occurred at this price with this market pants. Level I, what most brokers typically provide their customers, is
participant. also known as the “inside market.” It shows only the best bid and best
But a SelectNet preference to a market offer currently available in a stock.
maker works differently from a prefer- Level II quotes (the Nasdaq Quotes Montage) contain all market partici-
ence order to an ECN, because, among pants’ bids and offers — not just the inside market. So your broker, looking at
other reasons, market makers are his Level I quotes, may tell you that ABCD stock is currently bid at 10 and
allowed 30 seconds to respond to a offered at 10 1⁄16.
SelectNet preference order at their Fine. But what if you could see that there were only 100 shares bid at 10,
shown price/size. A market maker is below that another 100 at 97⁄8, and below that another 100 at 9 13⁄16, while
liable only for the number of shares on the offer there were 20,000 shares at 10 1⁄8, another 15,000 at 10 3⁄16 and
shown at the advertised price shown. He so on? This information would change your opinion of the current supply-
may trade more if he chooses, but if he demand balance considerably. In this example, you might not want to buy just
declines to trade more at that price then yet if hoping for a quick run-up, since there are very few shares on the bid
he must change his bid or offer accord- and many on the offer; prices may move down as supply overcomes demand.
ingly. But he still has 30 seconds to Level III quotes are what the Nasdaq market makers themselves have. Level
decide. These aspects of SelectNet are III is fundamentally the same as Level II — the only major difference is that
especially important because the market makers can raise and lower their bids directly through the Level III
“active” ECNs, like Archipelago, use quote window. By comparison, when you or I trade “direct,” we must go
SelectNet. through an ECN and a broker to do this.
SOES works differently. It gives small-
er investors and traders immediate fills
on up to 1,000 shares of Nasdaq stocks Which trade-routing method works ECNs — what they are, how they work
subject to regulations and rules specific best? The answer comes in two parts: and how they differ from the other avail-
to the use of SOES. SOES will automati- understanding the trading situation you able trade execution routes
cally execute against a market maker, are dealing with (Level II interpretation);
without his choice. However, it is impor- and knowing exactly how all the execu-
tant to know that SOES will not transact tion routes work. Level II is like a map — ECNs have been around since the 1980s,
against ECNs. if you know the routes well, you will when InstiNet, the granddaddy of the
know which one will get you to your modern ECN, began offering institutions
destination fastest. Nowhere is this more a venue to trade stocks in what has
Superior trade execution is all about important than if you are trading become known as the “third market.”
identifying the current trading situation “direct” (see “Direct access vs. online Until recently, though, this market was
and knowing which tool is appropriate trading,” ). largely unavailable to individual
for a given job. We will examine the ins and outs of traders. Since 1997, however, there has
M
any traders believe that because they are using an online broker, they do not. Some offer direct links to ISLD,
are “trading direct” — that is, participating directly in the Nasdaq or while others do not. Also, some may
NYSE markets. They are not. offer real-time display of the ISLD order
Standard online brokerage houses offer you the same execution capabilities book as an integrated part of the soft-
available over the phone — a keyboard has merely replaced the telephone ware, and some may offer full access to
interface. While this is extremely convenient, your executions are no more ISLD in the after-hours market.
under your control than when you say “buy” or “sell” over the phone. ISLD is open until 8 p.m. EST and has
At some point, a market maker or trader will execute your trade for you, tremendous after-hours liquidity rela-
and as you might expect, he must get paid. So your broker may take the tive to the other ECNs.
other side of your order (and profit from the spread), or even route your
order to a market maker for execution and receive payment for order flow.
An often overlooked aspect of the brokerage business is that broker-dealers One of the current problems in after-
can profit from their customers orders. For example, say a stock is bid 10 and hours trading is that ECNs are not con-
offered at 10 1⁄8. You want to buy the stock and enter a bid through a tradi- nected to one another and therefore can-
tional discount online broker, receiving your fill seconds later at 10 1⁄8. It’s not execute against one another. This
quite possible the broker “took the other side” of the trade, buying it at 10 creates arbitrage opportunities, a sure-
and selling it to you for 10 1⁄8. His profit ( 1⁄8 — $125 on a thousand shares) is to-be-short-lived situation some people
his fee for doing the trade. Was the low commission price of $10 worth it? are attempting to exploit.
Many traders say no and instead trade direct access, which allows them to try Several proposals are on the table that
to get a better price for themselves. will fundamentally improve price dis-
When you trade “direct,” you are able to show your bids and offers directly covery and execution in the after-hours
in the Level II quotes and effectively cut out the middleman (the market market (see “ECNs strive for level play-
maker or trader who would have handled your order had you placed it ing field,” p. 14). Keep in mind, though,
through a standard online broker). But with this opportunity comes the that because the ECNs operate like sepa-
responsibility of getting a better price for yourself. rate exchanges (even though they don’t
“Direct access” is really a misnomer. The Nasdaq and the ECNs do not deal have exchange status), you may not be
directly with private, individual traders. Brokers who offer direct access trad- able to access them unless your broker
ing allow you to use their sophisticated software and good name to bid, offer offers a direct connection to them in the
and execute at your discretion in real-time. Nevertheless, you are never real- hours after SelectNet has closed.
ly trading direct, even though you do have the ability to bid, offer and exe-
cute in the Nasdaq market at your discretion. You are still, technically, using
a licensed broker and a clearing firm to execute and clear your trade. The “active” ECNs all have something in
BY ALLEN SYKORA
T
he Fibonacci series is a number progression in which each successive
number is the sum of the two immediately preceding it: 1, 2, 3, 5, 8,
13, 21, and so on.
As the series progresses, the ratio of a number divided by the immediately
preceding number approaches 1.618, the “golden mean” found in the dimen-
sions of the Parthenon, the Great Pyramid and many natural phenomena.
Some traders use 1.618, its inverse — .618 (.62) — and other ratios (such as
.38 and .50) to calculate price targets and retracement points.
For example, if a stock rallied from 25 to 55, potential retracement levels
could be calculated by multiplying the distance of the move (30 points) by
Fibonacci ratios — say, .38, .50 and .62 — and then subtracting these results
fruition.”
After studying various forms of tech-
nical analysis, she has settled upon pat- High of 141 5⁄16
tern recognition as her trading method on 11/17/99
of choice. There are about 10 she looks
for, many based on Fibonacci ratios (see
sidebar). Enter long
“I approach my trading on nothing on 12/2/99
but the harmonic relationship of price
and time,” Simon explains. “I’m looking Approx.
at the random movement of price and 38.2%
I’m looking for certain harmonic levels retracement
that stocks seem to gravitate to. Stocks, Low of 129 7⁄8 (131 1⁄8)
for some reason, seem to gravitate to on 11/30/99
Fibonacci ratios before they make a
change either up or down.”
She looks for trends, then a retrace-
ment, often based on Fibonacci levels. Low of 114 5⁄8 on 10/18/99
The retracement levels she uses could be
as small as 38 percent or 50 percent, or
they could be 61.8 percent or higher. She Source: www.windowonwallstreet.com
will then buy or sell at the support or
resistance level implied by the retrace- from the high of the price move. In this case, levels of 43.6 [(55 - (30 *
ment percentage. .38)], 40[(55 - (30 * .50)] and 36.4 [55 - (30 * .62)] would result.
When Simon spots such a pullback, Figure 1 illustrates a trade Shelli Simon made in General Electric (GE).
she will wait one time period — one day The stock made a low of 114 5⁄8 on Oct. 18, 1999, and rallied to 141 5⁄16 on
if she’s trading on the basis of a daily November 17, a 2611⁄16-point move. The stock then pulled back to 129 7⁄8 on
chart (she uses both daily and intraday November 30, a little more than a Fibonacci 38.2 percent retracement of
time frames) — to make sure the pattern the preceding rally. Simon waited for a day (Dec. 1) to make sure the
is not violated. Then she will establish retracement was not violated, then entered long on Dec. 2.
W
really pulling at straws trying to find the simplest terms, this is what makes
technical analysis that would be simple the markets move.
hen Jerry Olson took up and work.” “It’s an actual picture of supply and
short-term trading in the Then a little more than two years ago, demand, and that’s what moves a stock.
mid-1990s, he studied while visiting the stock market chat site, Either you have more buyers or more
nearly every possible Silicon Investor, the retired general con- sellers. If you have more buyers, the
form of technical analysis: Gann angles, tractor became aware of point-and-fig- stock is going to go up. And if you have
Fibonacci retracements, cycles, oscilla- ure charting. He began studying it, and more sellers, the stock is going down.”
W
of the reasons I’m still here is that I’ve lasted 10 months, but Saidenberg man-
never allowed myself to get wiped out.” aged to squeeze some value out of it.
It doesn’t get much simpler than that. “One of my jobs was to make copies
hether you’ve just Saidenberg’s method of eluding wipe- of different market letters and give them
opened up your first outs has been to stick to mechanical trad- to the big guys in the company who
margin account or ing approaches. While he may not think liked to see them,” he recalls. “One of the
are managing mil- of himself as a perfect trader, he has market letters I really liked and always
lions of dollars, the basic rules of trading done well enough to avoid having “a made an extra copy of for myself was
are amazingly constant: Have a game regular job” (as he puts it) for all but 10 Systems and Forecasts, by Gerald Appel.”
plan, control risk and strive for consis- months of the past 14 years, evolving Saidenberg got a feel for both the equi-
tency rather than an overnight killing. from a somewhat fundamentally orient- ty options and futures markets during
Witness trader Richard Saidenberg, ed stock-picker into a systematic S&P his tenure and decided to leave the floor
president and chief trader of SoundView 500 stock index future, currency and and trade on his own. On the basis of
Capital Management in Pleasantville, interest-rate trader. Systems and Forecasts, Saidenberg further
N.Y. With 20 years of experience in the Through SoundView, Saidenberg has explored Appel’s research and writings.
markets under his belt and $10 million posted compounded annual returns of “I purchased a group of reports Appel
under management, he still attributes 252 percent, 95.5 percent, 8.5 percent and wrote called the Scientific Investment
”
1990 to January 1992 — 319 signals. I found that using intraday triggers
basis. for entry was a good concept. But to
AT: Did doing things eliminate the risk of overnight positions,
by hand like that I turned my 30-minute position systems
give you a better into day-trading systems. I’d have a
understanding of lower overall return, but much lower
the strategy? drawdown.
RS: Of course. It
forces you to look at AT: Was this a matter of adjusting the
every trade very time frame of the bars you used, or
closely and makes did you put in an automatic exit rule
you realize what all on the systems?
types of trades look RS: An exit-on-close rule. Also, I found
like, good and bad. that I moved away from indicators and
So when you experi- toward complete price calculations just
ence all the different using highs, lows and closes. I moved
kinds of trades in real toward trading threshold levels and
life you are ready to price breakouts: one level to first set up a
take them and con- trade and another level to enter the
tinue with your trad- trade.
ing system, as The levels are generally based on
opposed to someone either the range of a certain period of a
who just looks at a day, the entire day’s range or the previ-
performance table or ous day’s range. It really didn’t matter
equity curve and which time frame chart I was using for
70 and 30. The rules for buys and sells thinks, “Yeah, I can make that money,” those types of systems, because I was not
were identical. and then tries to trade it, not realizing using any indicator calculations that
When the RSI moved below 30, I’d there is a whole, long process to trading would require a specific number of min-
watch for the lowest value it reached after that can be difficult to endure. utes for the bars. Instead, I was using
moving below that threshold. Then I price action within a certain time inter-
waited for it to move back above 30. If it AT: Did you have a preference toward val. I found that by working with one-
made a bottom by coming down and then a particular time frame? minute or five-minute charts I could be
turning up, and the new bottom was RS: Trading very short-term — one- most accurate for system testing, even
within 10 RSI points of the initial bottom minute or five-minute time frames, for for a day-trading system which would
below 30, that was a basic buy signal. example — seemed like overkill. I might trade only a few times per month.
So, if the RSI made a bottom at 15, ral- have eight trades in a month with a sys-
lied above 30, then came down and made tem triggering off 30-minute price data. AT: Do you still use any indicators?
another bottom between 15 and 25, that But I could stand position trading, even RS: Yes. I still like to look at the stochas-
was a buy. If the spread was more than 10 though I preferred day trading. tics and RSI on my charts. Also, I create
points, I wouldn’t allow the buy — I’d But at the beginning I thought there custom indicators that are helpful in sys-
wait for a subsequent bottom. was a big advantage to position-trading tem development for making sure that
Sometimes I had two different bot- systems that were also sensitive to intra- when I’m writing a system it’s doing
toms working at the same time — the day movements and would adjust posi- what I expect. An indicator can help you
RSI would make a bottom at 5, move up tions during the day. For example, my track trades to make sure they’re behav-
above 30, then make another bottom at 30-minute RSI system was always in, ing correctly. I write all kinds of indica-
25 and again move up above 30. So, now long or short, with some positions last- tors that apply to certain systems.
I could have a following bottom to get a ing a few weeks even though I was
buy that was either between 5 and 15, or tracking the market intraday with trad- AT: You’re trading multiple markets,
between 25 and 35. If it went up from ing signals which were sensitive to intra- multiple systems and multiple ac -
”
because the absolute profit is not known ic rules; the problems have come when
at the beginning of the trade, as it is with and make money. I’ve tried to override those rules. Ý
THE
right? Well, there’s
more than one way to
calculate a stop level,
and some of the more
PERCENTAGES
popular ones can blow
you right out of the
water. Find out about
a rational way to
approach the problem.
BY THOMAS STRIDSMAN
one. For example, suppose you have real world. 1983 to April 1999, while Figure 2 shows
developed a strategy that will let you Consider another hypothetical situa- the absolute percentage change. The
catch all 1-percent moves in any stock. If tion. Say your 1-percent system is right straight lines that run through the charts
you apply this strategy to an S&P 500 only 50 percent of the time. Because of are best-fit regression lines — they reveal
index futures contract, with the market this, you place a $2,000 stop on every the underlying trend. As you can see
trading around 1,350 points, a 1-percent trade in case things don’t work out. from Figure 1, the line has increased
move would equal 13.5 points and be Again, using the S&P 500 futures con- from near zero to more than 30 points
worth approximately $3,375 (1,350 * .01 * tract as an example, you will still aver- per month. Contrast this to the regres-
250). age a $687.50 profit per trade (you’ll sion line for Figure 2, which has stayed
However, if you instead were trading make $3,375 half the time and lose $2,000 close to level (the slope is slightly down,
the E-mini, the same move would be the other half, when you get stopped around 3.5 percent per month).
worth only $675 (one-fifth the standard out). What these charts reveal is people
contract). For the Dow Jones and Not bad, but what about the other who say the volatility of the stock mar-
Nasdaq indices, with the markets trad- markets we mentioned? For the E-mini, ket has increased over the years, making
ing at 10,500 and 2,500, respectively, the the average trade would result in a $663 it more difficult to trade, are wrong. Yes,
same trade would be worth $1,050 and loss. For the Dow Jones and Nasdaq the dollar, or point-based volatility has
$250. For several individual stocks, the indices, the same number results in loss- increased considerably (Figure 1), but
dollar value would be too low to make a es of $475 and a $250 profit, respectively. this is only a natural consequence of the
trade worthwhile. So, for a good work- Of course, you could adjust the stop market trading at higher price levels. In
ing strategy to also be profitable, it needs accordingly for each market, as you did percentage terms, the volatility, if any-
to be applied to a stock that has a high in the stock trading example. A stop for thing, has actually decreased somewhat.
enough dollar value (or to a market that the E-mini would be set to $400, which This means if you use a fixed-size,
is trading at a high enough level). would result in an average trade making dollar-based stop in a market consistent-
If you’ve never traded and these are the questions you’re asking yourself, you’d
better take a step back. There’s a far more important question to answer first.
BY MARK ETZKORN goals of your business and establishing before A in the alphabet.
steps to accomplish them. Trading is never a hobby. It probably
• Make sure the business is adequate- requires more work than most other
ly capitalized, using the most conserva- businesses and often carries the unique
tive possible estimates. risk (if you trade on margin) of losing
• Start slowly, and put in the time and more than you initially invested. But, for
T
effort required of any entrepreneur those who approach the profession
attempting to launch a new business, soberly and with reasonable expecta-
expect your business to go through tions, the rewards are there.
he market has a knack for reg- rough times initially, and prepare your-
ularly making fools of even the self psychologically and financially to
best-prepared and conscien- survive this incubation period. There are certain realities to trading.
tious traders and investors; it • Make sure the business is adequate- They don’t have anything to do with
will utterly humiliate (or worse) the ly capitalized. (Yes, that’s twice.) wanting to trade or having the right or
unwary, lazy or foolhardy. Sounds fairly reasonable, right? But privilege to trade, but rather with being
That leads to a question almost never this is precisely what many — maybe able to determine whether you’re likely
asked — one that gets lost amid all the even a majority of — new traders don’t to benefit from trading. After all, the
excitement over a stampeding bull mar- do. goal is to make money. If circumstances
ket and point-and-click order-entry tech- Why? Maybe people tend to think exist that make this a less-than-likely
nology — but is nevertheless the most they know more about trading than they prospect, perhaps the best trading deci-
important thing would-be traders really do. Everyone sees the recaps of the sion you can make is not to trade.
should ask themselves: day’s market action on the nightly news The simple truth is that trading is not
Should I trade? (or watches round-the-clock financial for everyone. Just as some people are not
That very few people bother asking coverage), gets their quarterly 401(k) cut out to be engineers, lawyers, gram-
themselves this question before putting reports, or logs on to the Internet to mar school teachers or NBA point
money at risk at least partially explains check quotes and graphs and enter guards, some people would do them-
the low success rate of new traders. orders for their favorite stocks. selves huge favors in the financial and
If you were an engineer and wanted It makes it easy to feel like they really mental-health departments by not trad-
to start your own business in a com- have a handle on things, especially when ing. One study estimated there are fewer
pletely new field — say, open a restau- the Greatest Bull Market In History has full-time professional traders in the
rant — you probably wouldn’t do it on a had a nice habit of bailing people out of United States than professional athletes
whim. You certainly wouldn’t quit your bad (i.e., seat-of-the-pants) trades by con- — a sobering thought. (Maybe that point
job one day, dump your life savings into sistently rebounding — usually sooner guard dream isn’t so unrealistic after all.)
your new business, and, without know- rather than later. Anyone can do it, right? Obviously, trading for a living is not
ing the first thing about what you were And if you think being a part-time easy and it’s not something that can be
doing, expect to make an easy killing. trader means you don’t have to put in mastered overnight. It’s a business, and
If you were smart, you’d probably: the time and effort a full-time trader to succeed in it you should expect to
• Spend a great deal of time research- does, think again. You’ll still be compet- invest the same kind of time and equity
ing your new field, consult with profes- ing against full-time traders, and full- (both real and sweat) you would to
sionals in the business and even try to time traders tend to be people you’d launch any other business. You should-
gain some hands-on experience. describe as Type-A personalities only n’t trade because you think it’s an easier
• Put together a plan outlining the because there isn’t a letter that comes or faster way to make money than open-
ing a restaurant. You should trade trade is more complicated than simply tion. “Risk slope,” shows the inverse
because you think it’s a better way to meeting your brokerage’s minimum relationship between how much money
make money than opening a restaurant. account balance requirement. It’s the (in terms of percentage of income or net
And there should be a reason you think end result of the interaction of your age, worth), relative to age, a person could
that way, a reason that has nothing to do net worth, outside financial responsibili- probably devote to short-term trading.
with luck or wishful thinking. ties, risk tolerance and specific trading The downward slope of the money
Sufficient time (both for learning the plan you intend to follow. line is based on a few assumptions. First,
profession and practicing it), persist- Pressured traders are never good when people are younger, they generally
ence, a love for the business and, yes, traders, and if you have too little money have few financial obligations and are
some aptitude are a few oft-quoted char- — or your trading equity represents too thus freer to speculate with more of their
acteristics of successful traders. These big a portion of your total worth — you money — they have more time, and
certainly are key components to tackling will be apt to make poor (read: emotion - years of future income, to bounce back
the markets (or any other business, for al) trading decisions, or you simply will from any setback. As people get older,
that matter), but they are rendered moot not be able to weather the natural they tend to assume greater financial
by something far more academic. volatility that accompanies many trades burdens (mortgages, children), so the
Money. before they are profitable. percentage they can risk probably will be
A little common sense goes a long limited — you don’t want the kids’ edu-
way here. Putting half your net worth in cation cut short because you risked the
The No. 1 reason, by far, most new a trading account is one kind of proposi- college fund on a “hot” IPO that went
traders fail is the same reason most new tion for a single 29-year-old with no cold. Finally, as people approach retire-
businesses of any kind fail: lack of capi- debt, and another entirely for a 49-year- ment, preservation of capital hopefully
tal. You can talk about discipline and old with a mortgage who also is facing becomes the key goal. Speculating with a
strategies all you want, but the greatest putting two kids through college in the large percentage of the funds you need to
trading approach in the world won’t do next couple of years. Similarly, someone take you through the rest of your life —
you any good if you don’t have the in or approaching retirement would be when you will have less time and ability
money to trade it. wise not to risk a substantial portion of to replace them — is hardly prudent.
Determining how much you need to his or her wealth in short-term specula- Keep in mind, though, that because
Short-term strategy,
You’re a short-term trader —
what do you care about
investing, the long-term trend
or what’s happening in the
larger economy? Find out why
traders who understand
longer-term approaches
(and investors who understand
trading) have an edge over their
one-dimensional competition.
you expected it to), or as a short-term bet ing,” and it consists of combining sever-
BY THOMAS STRIDSMAN that allows you to jump from one “ship” al related indicators and so-called
to another — if that ship can take you to “expert commentaries” on top of each
C
your destination more efficiently. One other in the hope that one day, when all
major advantage of trading short-term in these signals simultaneously flash green
the direction of the long-term trend is lights, you will have a sure winner. (And
that you can dare to work with limit in the meantime, it sure looks fancy.) The
all it the Titanic rule. orders, trying to pick tops and bottoms. problem is that these indicators will all
You cannot, in an instant, turn around Of course, doing so takes discipline give different signals; with 10 indicators
a massive ship sailing full steam ahead. and a thoroughly researched arsenal of on your screen and only one being
Its mass and momentum will make the entry strategies, and stop and exit tech- “right,” you actually have a 90 percent
process long and slow. The same goes for niques, but that is a topic for another chance of coming to the wrong conclu-
the economy, or any smaller part of it, article (or an entire book). For now, we sion if you look at them one at a time.
such as an individual stock. Strong trends will focus simply on trading with the The odds get even worse if you start
generally keep going — with some twists trend and how that trend can be meas- combining them.
and turns along the way — until some- ured with the help of different technical Once you are past the piling stage
thing big happens to reverse them. analysis tools. (which you probably are, since you have
To be sure, strange things happen in read this far), the next step is to see if
the markets now and again, bringing there really is anything to be gained from
short-lived fame and fortune to a lucky Basically, there is one way to fish out trading only with the longer-term trend.
few. However, you cannot count on such high-probability trading opportunities. You can determine the longer-term
exceptions to be the rule. Generally First, ask yourself, “Is it better to trade trend several ways. The simplest (but
speaking, you are much better off going with the long-term trend, and can the certainly not the easiest) approach is to
with the current flow of events — swim- short-term volatility help determine the use your own fundamental and discre-
ming with the economic tide instead of outcome of the trade?” Then, do the nec- tionary judgment about where the econ-
fighting it. essary research to find the answers. omy in general, and your stocks in par-
For short-term traders, this means Well, there is another way, but it does ticular, are headed, and then stick to that
going with the flow of the market and not work — even though it is especially prognosis over a long period of time.
only placing trades in the same direction popular among new traders (and, horri- Other ways could be to trade only in the
as the trend, either as a long-term bet to fyingly, some brokers who make their same direction as a lengthy moving aver-
catch the beginning of a move (but being livings exclusively off your commission age (e.g., 50, 100 or 200 days) or some
prepared to get out as soon as the market dollars instead of in the markets). other “long-term” indicator.
makes it clear it is not heading where This method is called “indicator pil- Table 1 (opposite) compares the results
P
rofit factor simply is the ratio of every dollar gained and every dollar lost lation, the OBV covers everything there
by a trading strategy. For example, if you have a strategy that makes two is to know in terms of technical analysis
trades, one a profit of $2 and the other a loss of $1.50, the profit factor — namely, the psychology of the masses.
for that strategy is 1.33 (2÷1.5 = 1.33). This means that for a strategy to be prof- Figure 1 shows you what this indicator
itable, it must have a profit factor greater than 1. The higher the profit factor, looks like plotted together with price.
the greater a strategy’s expected prof- One important thing
itability. to remember when
Standard deviation, on the other THE BELL CURVE 68% looking at this chart is
hand, measures the disparity of the One standard that the trend, as you
deviation
trades a strategy produces — that is, decide to define it, does
Two standard Two standard
how much they vary from an average not necessarily have to
deviations deviations
value. coincide with the actu-
For instance, if we calculate the al trend of the price
average of a random series of values chart. For example,
(say, trade results from a particular according to this indi-
strategy) several times, the closer cator, the trend for the
each individual average is to all the stock market had been
others, the lower the standard devia- Mean value down since July 1998,
tion; and the lower the standard devi- although prices have
ation, the more secure we can be not fallen that much (if
about how representative the average is for future samples. at all). In this case, however, the OBV
Measuring risk: To use standard deviation as a risk measurement, you simply indicator tells us the downside volume
analyze the cumulative trades of a particular strategy. The larger the standard has increased while the upside volume
deviation, the less confidence we can have in projecting the strategy’s results has decreased, making it increasingly
forward in time, and the larger risk we take if we go ahead and place a bet on difficult to trade any rallies successfully.
these results. What we are looking for is a lower standard deviation — more sta- (Keep in mind there is nothing to pre-
bility, and thus predictability, in our trading approach vent you from using several different
Also, if a distribution of trading results is said to be “normally distributed” strategies based on several different
(remember the bell curve from your old math class?), a one standard deviation trend-filters. The main thing is that you
calculation will hold approximately 68 percent of all results. In other words, if stay consistent with your beliefs and
the average of several samples is 1.21 and the one standard deviation boundary trust in your research.)
comes out to 0.11, we can say that we are 68 percent sure the true average for Now let’s see how this long-term
the whole population of values will be somewhere between 1.10 (1.21 - 0.11) trend filter combines with a short-term
and 1.32 (1.21 + 0.11). trading technique. The rules for entering
If you are interested in more of the mathematics, check out HyperStat Online the market, at the close, on the long side
(http://davidmlane.com/hyperstat/index.html). It’s an excellent resource for will be:
information on standard deviation and other statistical concepts.
I
hardware and software, trad-
ing advisory services, trad-
n 1783, the United States finally ing seminars, books and
won its independence in a war other expenses. systems in this country today — one for
started over unreasonable taxation. Here is an even more shocking fact: those with businesses and one for those
The issue at that time was an annu- The average trader or investor will pay without. Non-business owners are enti-
al tax of approximately $1.33 per person more in taxes over his or her trading or tled to a few itemized deductions, taken
— a tax rate of less than .03 percent. investing career than on all other “below the line” (as subtractions from
Imagine what the Founding Fathers expenses combined. adjusted gross income). In the 1986 tax
would say today, when federal, state and Yet few traders take the time to incor- act, the non-business owner investor got
local income taxes; social security, porate tax strategies and planning into doubly whacked: available deductions
Medicare and self-employment tax; and their overall trading plan. They are so were increasingly phased out.
excise, sales and real estate taxes usually caught up in the trading process they fail Business owners, by contrast, have
absorb more than 60 percent of a taxpay- to plan for the tax consequences of what always been given special treatment.
They get to deduct all kinds of ordinary
business expenses — dollar for dollar —
The average trader or investor “above the line” (to arrive at adjusted
gross income). These deductions are far
greater, both in number and amount,
will pay more in taxes over
his or her trading or investing career
er’s income. And if that were not bad
enough, death is no relief from taxa-
tion. When you die, the government
takes what they missed while you
were alive: Federal and state estate
than all other expenses combined.
taxes can decimate the wealth you
have built up over a lifetime, often esca- they are doing. and are taken in a much more advanta-
lating to another 60 percent tax on what Although traders will routinely tell geous place (that is, one that will save
is left for your heirs. you they are shooting for 20- to 30-per- more money) on the tax return.
Obviously, taxes still have a great cent average return on their capital, by From a tax vantage perspective there
impact on everyone’s life. But nowhere is disregarding tax issues they are not con- is now a new breed of investor — the
the impact greater than on active traders. sidering their true return. “active trader.” Savvy active traders
One of the biggest reasons for this is After all, it is not just how much who know about their benefits under the
the Tax Reform Act of 1986, which money you make trading, but how much tax law can reap all of the advantages of
turned traders and investors into sec- you keep. a business owner. This knowledge can
ond-class citizens. Because of this law, impact his or her bottom line immensely.
taxes are often traders’ and investors’ To understand the exact nature of
single largest expense — which is saying I have always thought there are two tax what a trader does, and his or her tax
400,000
Rules: Go long if the market closes down two
days in a row in the same week (following a 350,000
down week), except if this coincides with the
market setting a new 60-day low (which suggests 300,000
a possible downside breakout). Reverse the rules 250,000
for the short side.
200,000
Exits: Stop out immediately if the market moves
against you 1.1 percent; lock in a profit after a 150,000
move of 0.6 percent or more in your favor; exit 100,000
immediately if market moves 2.8 percent in your
favor. Exit any open positions after eight days. 50,000
0
1/9/90 1/8/91 1/7/92 1/5/93 1/4/93 1/3/95 1/2/96 12/31/96 12/30/97 12/29/98
SYSTEM SUMMARY
Time
Source: CSI, Unfair Advantage
Profitability Trade statistics
End Equity ($): 374,383 No. Trades: 474
Test period: Oct. 9, 1990 to Oct. 27, 1999.
Total (%): 274 Avg. Trade ($): 610
Year (%): 14.42 Tr/Mark/Year: 48.4 Test data: daily S&P 500 stock index futures prices; $50
P factor: 1.23 Tr/Month: 4.0 deducted for commissions and slippage per contract traded.