A DAY TRADER'S SECRETS
By George Kleinman
Why is day trading so popular? In a word, itís seductive. There are those who believe day trading is an easy way to make a killing (but these are the people who get killed!). It looks to be liberating (but in reality day traders are slaves to their screens). The myth abounds that one can effectively day trade with a lot less money because you donít need to worry about overnight margins. In reality, those who are not adequately capitalized will ultimately drown in the financial sea. It may look exciting, but those who day trade for excitement only end up lost and dying of thirst in the financial desert.
After thousands of day trades, I can tell you this; day trading is much more demanding than position trading. It takes total focus and total concentration.
It is true that advances in technology and the Internet offer better opportunities for day traders. The democratic dissemination of information has leveled the playing field to a major extent, and today traders no longer need to sit by the phone waiting for their broker to call them with fills. Yet, the odds are still stacked against the day trader, so the big question is why do it?
Well, there are positives. The big one it that you do not have overnight exposure, with its associated overnight stress. Day traders have a fresh start each and every trading day. They sleep like babies, not having to worry about Central Bank intervention or how tomorrowís USDA Crop Report might help or hurt them. Then there is the element of instant gratification which, trust me, can be very emotionally rewarding. No doubt, the shorter time frame does make for (all other factors being equal) lower risks, and without overnight margin requirements the leverage can be greatly magnified. Then again, the greater the trade activity the greater the costs, and I am not just speaking in terms of commissions. Since slippage (price fills other than what you anticipate you will receive, or what you see on the screen when your order is submitted) is such an important cost of trading, it is imperative you find a brokerage firm that has excellent trade execution capabilities for the markets you trade. Slippage, in my opinion, is of even greater importance to bottom line profitability than fees, and it takes on an even greater significance when day trading.
In this article I plan to share with you my ìsecretsî learned from twenty years of day trading. These secrets are absolutely essential to successful day trading. I will conclude by disclosing a simple strategy that has worked for me.
YOUR NINE ESSENTIAL DAY TRADERíS RULES
YOU WILL NOT BE A SCALPER. Pit traders can successfully scalp for a few ticks because they have enormous scalperís advantages. They can buy the bid and sell the offer (you generally cannot), and they pay extremely low fees as Exchange members (fees which can make trading for just a tick at a time profitable). Floor traders can react instantly to big orders as they hit the pit, they can hear the noise rising and know something is afoot, you canít. On the other hand, off the floor can be a big plus because you will not get caught up in the emotions of the pits, which often result in false messages.
YOU WILL BE A DAY TRADER, NOT A DAILY TRADER. A day trader by definition is in and out the same session, but nobody can do it successfully every day. The right kinds of market conditions are not present every day, and it is psychologically too intense to day trade day in and day out. One tremendous advantage you have is freedom of choice, you do not need to take every signal or trade every market. You do not need to be in a position before an important, but risky, employment report. You have the luxury to wait and watch and witness the marketís reaction before taking action. If a market is ënewslessí and quiet, or range bound, you can always relax and let your most important quality of patience work for you.
YOU WILL TREAT DAY TRADING AS A BUSINESS. It is not a part time diversion. It is very demanding. You need total focus and total concentration. To be totally focused you must eliminate outside distractions. Lock your door if you have to. I know from personal experience, the more outside annoyances, the harder it is for me to trade effectively.
YOU WILL FEEL GOOD. If you do not feel well, you cannot day trade effectively. If you stayed out late last night drinking, or are physically ill, or have emotional stress from outside influences, you should not do any kind of trading and this is especially important when day trading. Day trading is much more demanding and it is absolutely essential you be sharper and quicker than your competition. When the optimal ëset-upí presents itself, you must feel strong, because you will not have the luxury of hesitation!
YOU WILL BE TOTALLY DISCIPLINED! Period. What this means is you will follow written and well-defined rules systematically, which is the only way to avoid the emotionalism of the markets. In other words, you will construct a game plan, which you will follow without bias. Let me repeat this, you will have NO biases. (I have always had my biggest losses when I have had a strong opinion about some market and overruled my technical game plan.) If you do not follow your game plan, you will miss some of the best and most profitable trades. Sound familiar? What will your game plan look like? It will have well defined entry and exit rules from a program or system you have tested and have confidence can win over time. Your well-tested system will have a positive outcome (not necessarily a high win to loss ratio, which is not easy to achieve for any system). If for every dollar you lose your system over time makes $2 on winning trades (after fees and slippage) then a marginally positive win to loss ratio will still result in profitability. The best day traders are on autopilot, and just like a seasoned pilot, they operate without emotion using well-defined protocols. Your rules will be very strict in terms of capital preservation, especially during drawdown periods. (While yours may be better, let me tell you about my money management rules. I will not tolerate a drawdown of greater than 5% in any single day. This is a moving target, in other words if I have paper profits this 5% drawdown number is off of a peak, so if I am up 1% I move my stop up 1%. 5% is a maximum risk, most days I risk much less. To determine where my stop is placed, I use a 4% number to calculate position size, with the extra 1% a cushion for slippage and fees.) Total discipline means you will always use stops (just do it), and never cancel a stop just because the market is getting close to it. Finally, never add to a losing position.
YOU WILL NEVER LET A DECENT PROFIT TURN INTO A LOSS. Here is what I do: if I have a reasonable profit on paper, I move my stop up so that, if half of these profits slip away, I am gone for that day. The reason is obvious; in this way you escape with at least a portion of your profits.
YOU WILL BECOME VERY CAUTIOUS AFTER A ìHOME RUNî. After you make a big hit, the temptation to overtrade grows geometrically. After a home run, look for singles (or better yet, take a vacation).
YOU WILL GO ONLY WHERE THE ACTION IS. It is essential to be aware of the current trading environment. Day trading requires volatility and liquidity. Not all markets are volatile enough to allow for ranges required for consistent profitability; you need a market that not only moves, but moves within a limited time frame. You shouldnít day trade markets like oats. Not all markets are liquid enough to minimize slippage. You shouldnít day trade markets like lumber. Even large markets should be avoided when they are quiet and/or range bound. Look for markets in the news. Of course, there will be times you think a market is going to be a mover but then it dulls up on you. Personally, if I am in a day trade which is going nowhere (after a reasonable time has passed), I will use my discretion to get out early. It does seem the best day trades work right away, and many times with little or no grief
YOU WILL DAY TRADE ONLY MARKETS SUITED TO YOU. Not every market is suited to everyone and there is no rule that says you have to trade anything and everything. While the S&P is todayís day traderís favorite, but I personally donít like it. It is too erratic, and in my experience the slippage and risk are too high. Better suited to my personal temperament for day trading are the currencies, crude oil, bonds, and (when active) the soybeans and metals. Make a personal choice because nobody is holding a gun to your head to trade the market du jour. One more thing, you need the right temperament to day trade. If you require numerous confirmations, or only can take action after extensive research, you are probably not suited to day trading. Additionally, Iíve found, (maybe due to a simple mind), that simple is better. Keep it simple! Some of the most basic indicators can be incredibly profitable if you follow the rules I have outlined above.
THE TREND REVERSAL DAY TRADING SYSTEM
There are numerous wrong and no doubt fewer right ways to profitably day trade. The right ways come in different flavors and each trader has to discover his or her own. Here I present just one method, not the Holy Grail, but it works for me. It combines two simple, yet effective and well-known indicators; the RSI and the simple moving average.
For the record, I am a trend follower. In other words, I do not try to pick tops or bottoms since I personally have found this just too hard to do. I would rather let the trend work for me, and find it easier to target a ‘piece of the middle’. Recall what I said previously about not having a bias. This is particularly important when day trading. When using this method, we are only interested in exploiting the trend for that day; the major trend is irrelevant. A requirement is a volatile, high volume market. We need to use our discretion and best judgment to exploit the trending days and strive to remain on the sidelines during choppy, low volume days. How do we recognize the trending days? They tend to follow lower volume consolidation periods, will develop on breaks of significant chart points, generally with higher than normal volumes, and particularly on news days. You must be prepared and ready to act on days when news breaks, for example when government reports are released. Always watch for gap opens. It is important to note that it is not the news, rather the reaction to the news, which is important. Your job is not to interpret news, but to correctly read the trend of the day. You must act without hesitation when you get a signal, then you need patience after you take the signal. Even the best of trend days will not trend all day, as there will be intra-day periods of consolidation which might only be rest periods, nothing more. You must always use stops, because no method works all the time. Finally, play it out to conclusion. At times your biggest profits will come in the final fifteen minutes of the day.
PARAMETERS: Use a bar chart, bars no shorter than 15 minutes and no longer than 45 minutes. A shorter time frame generates too much noise and with a longer time frame, the risk is too high. For the trade examples below, I use 18 minute bars. Use 23 & 30 period simple moving averages and a 9 period RSI.
RULES:
A SIGNAL IS GENERATED AFTER A ëTREND REVERSALí. A ëtrend reversalí from down to up occurs when the market moves from trading under both averages, to above both averages. A ëtrend reversalí from up to down occurs when the market moves from trading above both averages, to below both averages.
A TREND REVERSAL CAN ONLY OCCUR AFTER A ëSET UPí. For a ëlong set upí to occur, the market must have one bar close above both averages (if previously below). For a ‘short set up’, the market must have one bar close below both averages (if previously above).
WHEN THE HIGH OF A LONG SET UP BAR IS EXCEEDED, A BUY SIGNAL IS GENERATED. WHEN THE LOW OF A SHORT SET UP BAR IS EXCEEDED, A SELL SIGNAL IS GENERATED. Use a buy stop to enter on the long side, and a sell stop to enter on the short side.
TAKE A BUY SIGNAL ONLY WHEN THE RSI IS < 60. TAKE A SELL SIGNAL ONLY WHEN THE RSI IS >40. This rule will filter buy signals in potentially overbought situations, and filter sell signals in potentially oversold situation.
YOUR INITIAL STOP IS A REVERSAL SIGNAL, or a maximum 4% of your gross equity (5% including estimated fees and slippage). If by risking 4% of your gross equity you cannot place your stop comfortably on the other side of the averages, do not take the trade since the risk would be too high. (For most of the markets I trade the risk is at least $400 gross per contract not including slippage and fees, which requires $10,000 in free equity per each single contract traded. When trading markets such as the large S&P, the risk will generally be quite a bit higher requiring a larger account size.)
WHEN THE RSI MOVES <25 (ON A SHORT) OR >75 (ON A LONG) THEN LOWER/RAISE YOUR STOP TO THE HIGH OR LOW OF THE PREVIOUS BAR. Once you have reached this step, you are tightening your stop in the exuberance phase or fear and panic phase. In many cases, you will be stopped during the next bar period, but in most cases by now you have locked in a decent profit (equal to at least your risk, and in many cases much more). This is a dynamic rule, in that you will continue to move your stop to lock in additional profits as the market continues to move your way. If your new stop is not hit during the session, then liquidate the position at the market on the close. It is important to hold the position all the way until the end of the day if you can. At times, this will result in what I call a ìmega profitî trade. You only need a few mega profits each year to really make your year!
Example 1: Long Bonds (September 30th). This was a ìnews dayî with no less than five major government reports, including the important quarterly GDP (all released 10 minutes after the open). The numbers were somewhat conflicting, and after the releases the market continued to trend lower, but then about an hour into the session reversed and ëset upí (Bar 8). The RSI on ëset upí was 52, so since it was under 60 this was a valid signal and we prepared to take the trade by placing our buy stop one tick above the high of Bar 8. A long position was initiated when the buy stop was elected (Bar 9) at 11320. A protective sell stop was initially placed at 11307. On this day, the RSI never traded above 75 so we were never able to tighten our stop. Since the initial stop was not touched, the position was liquidated at the close (Bar 23). It is interesting to note that the trend for this day had nothing do with the overall trend; in fact the major trend was down and the market did gap open lower on the following day (Bar 24). The fact we were day trading made this overnight risk a moot point.
Result: Long from 11320, sold on close at 11330 for a day trade profit of 10 ticks ($312.50 gross per contract).
Example 2: Short Euro (November 4th). This was also a ìnews dayî, one requiring action without hesitation. Prior to the market open, the European Central Bank raised interest rates. This was ostensibly bullish news, and the market gapped up at the open (but did so in a lukewarm sort of way). It traded modestly above the averages for the first six bars. The trend reversal came approximately two hours into the session (Bar 7 with the ëset upí, and Bar 8 with the sell signal). On the ëset upí bar the RSI was above 40 (at 45), so we took the signal, and prepared to take the trade by placing a sell stop one tick under the low of Bar 7. The short was filled at 10500 when the sell stop was elected at 10502. The initial protective buy stop was placed at 10542. When the RSI moved below 25 (Bar 13) the stop was lowered to 10482 (just above the high of the previous bar). The stop was again lowered to 10474 or just above the high of Bar 13 at the start of the Bar 14 period, again to 10436, or just above the high of Bar 14 at the start of 15, and again to 10406 at the start of 16. If the market continued to trend lower into the close we would have continued to lower our stop with each subsequent bar and cover at the close. In this case, however, the stop was elected and filled at 10406 during the Bar 19 period.
Result: Short from 10500, covered at 10406 for a day trade profit of 94 points ($1175 gross per contract).
George Kleinman is an Exchange member, President of Commodity.com (online futures brokerage), and CEO of the full service brokerage firm, Commodity Resource. Email geo@commodity.com
Futures trading involves the risk of loss, past performance is not indicative of future results, and there can be no assurance the concepts presented in this article will be profitable.
Founder: The Free and Clear Foundations of Earth, Chairman & CEO Penny King Productions, The Free and Clear Bancorporation, Senior Trustee; The Free and Clear Fund, and Janitor for the Global Morass of Debt Instruments.
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