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Daytrading S&P: The Hardest Game in Town
By Jake Bernstein
RealMoney.com Contributor
8/29/2006 4:02 PM EDT
URL: http://www.thestreet.com/p/rmoney/technicalanalysis/10306299.html

The rapid growth of low-cost computer technology, virtually instant communications afforded by the Internet and lightning-fast order execution have created conditions highly favorable to daytrading. Significant intraday price swings and volatility have added to the recipe.

This has attracted thousands (if not, in fact, hundreds of thousands) of new traders to the markets, all seeking to participate in the apparent but illusory promise of daytrading riches.

All too often, what is apparent in the markets may not be real. Joseph Granville, "father" of the on-balance volume theory of stocks, summed it all up very clearly in his oft-repeated warning: "If it's obvious, then it's obviously wrong."
From what I have seen in my travels throughout the world, the majority of S&P daytraders lose money at this fast-paced and exceptionally difficult game. While it seems relatively easy to be successful in daytrading, the reality is the opposite of what one might expect. Why? With any hope, my observations will help shed some light on the situation. If you are one of the many who can't seem to win at the S&P daytrading game, my thoughts might help steer you in the right direction.

The Metamorphosis of a Game

Poker has been getting a lot of publicity lately. You can play online, you can play poker video games, you can play the poker machines in casinos all over the world, or you can play "real" poker at a poker table.

Assuming you are new to the game, what would you do first?
Without a doubt, you'd want to learn the basics of the game before you risk any money at it. Then, assuming you feel you have a working knowledge of the rules and strategies, you'd get practice.

You could practice with friends using play money until you hone your skills, and then you might graduate to a video game and eventually to a casino video game using small bets. Finally, after considerable practice both at poker machines and with friends using small stakes, you might decide to try your hand at a table with strangers.

When it comes to real money, the emotions of the game can work for you or against you. If you have learned the mechanical strategies of the game, and honed the ability to evaluate and use your opponents' behaviors as part of your strategy, then you are on the way to becoming an expert. However, if you are still relatively new to the game, you will likely become grist for the mill if you play with those who are far more experienced.

Indeed, as a newcomer, you will learn many expensive lessons at the hands of professionals, whose sole goal is to take your money from you.

Trading Against Professionals

While I believe that the odds of making money as a trader or investor are far better than the odds of making money as a gambler, there are some limited but meaningful similarities.

You'll need to:
• understand the rules of the game;
• practice considerably before you risk any money;
• pay attention to small details that can make all the difference between success and failure;
• have risk capital to begin playing the game;
• be prepared to take losses; in fact, you must be prepared to take a number of consecutive losses;
• control your emotions, keeping fear, as well as greed, in check;
• have a systematic approach with objective rules and strategies;
• know when to take your losses;
• know how to maximize your winnings.
I suggest that without these prerequisites, any success you achieve will be the result of "dumb luck." Luck doesn't last.

It's a terrible way to make money.

Daytraders Take Heed

Consider the lot of most daytraders. They come into the game perhaps as a result of reading an ad or hearing from a friend who has a friend who knows someone who has made "a ton of money" daytrading e-mini S&P futures.

They read a few articles here and there, or worse, they buy a trading "system" that makes amazing claims. They pull together a small stake of risk capital and, before they have met all of the requirements noted above, they open an account and begin trading online. They're amazed at how fast their orders get filled. They love the game, but they're dismayed at how fast they lose money.
Yes, they make a few dollars here and there -- just enough to keep them pulling the handle of that "slot machine." However, their net result is usually a loss. Why? Simply because they have not fulfilled any of the prerequisite conditions for success as noted above.

Many of these same individuals wouldn't think of running their own businesses without a plan. The irony is both obvious and sad. But the worst is yet to come.

Volatility -- Friend and Foe

Market volatility is at one and the same time the daytrader's greatest friend and worst enemy. When a market like S&P futures makes large intraday moves, it creates profit potential. In doing so, it creates opportunities. But opportunity is only one side of the coin.

With all opportunities come risk. On a typical day, the average price range (price difference from the high of the day to the low of the day) of S&P futures might be about 800 points (8 basis points). Frequently, the range will be 10 basis points or more. In the full S&P 500 futures contract, a range of 10 basis points equals $2,500 in value. In e-mini S&P (which is one-fifth the size of the full S&P contract), this translates into a $500 daily range.

Most daytraders new to the game are laboring under the false impression that a small stop loss will protect them from big losses. Think about it. If the daily trading range is $500, then a $250 stop loss is likely to be hit, unless your timing is almost perfect. Given that most traders have mediocre timing, the odds are that you will be stopped out at a loss more often than not.

The common assumption that small stop losses protect you as a daytrader is not, in my view, correct. You need a stop loss that is fairly large, or at least large enough to compensate for the random intraday fluctuations.

There's even more that daytraders should know about how to improve their odds of success. Look for a follow-up column in which I'll use charts to illustrate my points on the subject.