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Cheat Sheet / Updated 02-22-2024

If you want to get started in day trading, doing some preparation before you dive in dramatically increases your odds of success. From setting up your trading business (and it is a business) and learning trading jargon to tracking the markets with technical indicators and calculating your performance, these articles get you on your way.

Cheat Sheet / Updated 01-06-2023

Hedge funds use pooled funds to focus on high-risk, high-return investments, often with a focus on shorting — so you can earn profit even when stocks fall.

Article / Updated 07-02-2021

Let's keep it real: day trading is a bad idea for most people. So, if I keep you from taking up day trading because it’s the wrong thing for you to do, then I have done my duty. It requires a strong personality; someone who can face the gyrations of the markets day in and day out. And it also requires someone with enough attention to detail to run a business. It’s a great career option for the right person in the right circumstances. But for people who have trouble keeping cool or who don’t have the patience to learn how to trade, and for anyone who has a gambling problem, day trading can be a quick road to ruin. Here are eleven signs that may indicate day trading isn’t right for you right now. Take these signs seriously. Most day traders lose money, in part because a lot of people who aren’t cut out for day trading try it anyway. 1. You want to discover investing by day trading Many people want to manage their own investments. Although doing so is certainly possible, you first need to take the time to learn about the basics of finance, such as the relationship between risk and return, proper diversification, and time horizons that are appropriate to your situation. In fact, there’s a great book called Investing For Dummies by Eric Tyson (John Wiley & Sons, Inc.) that can help. Some people confuse investing with day trading, though, and these two disciplines are not the same. Day trading involves rapid buying and selling of securities to take advantage of small movements in prices. This can be a successful strategy for part of your investment account, but day trading with all your money isn’t a good idea. Buying and selling securities on your own without being a day trader is entirely possible. Making money in the financial markets without being a day trader is entirely possible, too. And if you don’t know another good term for “self-employed person managing her own money,” just tell people you run your own hedge fund. You’ll get better tables at restaurants that way. 2. You love fundamental research Fundamental research is the process of analyzing a company to see how good its business is and what the company’s securities are worth. Fundamental analysts crunch numbers, build forecasts, check out products, and look for stocks that are going to do well over the long term. They dream of uncovering the next Google or the next Walmart and holding the stock all the way up. Fundamental research is antithetical to day trading. Day traders look for profit opportunities in short-term price movements. They often do not know what industry a company is in, nor do they care. If you love the fundamentals, you’re probably too analytical to be a good day trader. 3. You’re short on time and capital Getting started in day trading is a lot like buying a small business. It takes commitment of both time and of money. If you don’t have enough time, learning technical patterns is difficult. If you don’t have the money, you won’t be able to work through rough cycles. And there will be rough cycles. That’s day trading’s only sure thing. Some day traders are able to trade part time. If you are disciplined, you can be successful as a part-time trader. The key is to close out your positions at the end of your designated trading period as though the market day were ending. If your plan is to trade for two hours a day, then trade for two hours a day and no more. Use an alarm clock as your personal trading bell. 4. You like working as part of a group A decade ago, most large cities had day trading offices, called trading arcades, where traders could go each day to buy and sell securities. The big advantage these firms offered was high-speed Internet access. Now almost everyone can get high-speed Internet access at home, so there’s little need for day traders to go elsewhere, and most of these offices are closed. Working at home is great for some people. If you prefer camaraderie during the day, like the support of a team, and want friendly faces around you, you’re likely to be miserable day trading. It’s just you and the market, and the market doesn’t have a great sense of humor. 5. You can’t be bothered with the details of running a business Day traders are small-business people, and their entrepreneurial flair goes beyond making their own buy and sell decisions. They also buy equipment, shop for supplies, and maintain careful income tax records. To some, this is exhilarating. No more mean office manager who decides how many and what kind of pens must be used. No more going through hoops and bringing in letters from a doctor to get a fancy ergonomic chair. You’re the boss, and if you want it, you can have it. But to others, all this responsibility is overwhelming. Picking out pens? Creating backup procedures? Worrying about accounting software? It’s too much. If the mere thought of standing at the office-supply store gives you the heebie-jeebies, you may want to consider trading as an employee rather than trading for your own account. 6. You crave excitement Trading seems so exciting. You’ve seen the stereotypical picture of the people on the floor at the Chicago Board of Trade, wearing bright-colored jackets and loud ties, screaming and waving their arms. It gets my blood pumping just thinking about it. Of course, they were probably shouting out coffee orders and waving their arms in a debate over the Cubs versus the Sox. And anyway, floor trading is mostly obsolete. Most of the large stock, bond, and derivative exchanges have gone through mergers and reduced the square footage of their trading floors because of changes in how people trade. Nowadays, most traders sit in offices in front of computer screens. They have to stay focused on the little blips in front of them, and it can be deathly dull. Some days few, if any, opportunities come up to trade using your system. If you crave excitement and have trouble staying focused, you may find that day trading is too boring for you. It can involve intense stress with few opportunities to work it off during the day. 7. You’re impulsive With the frenzy of trades and the rapid-fire decisions involved, day trading may seem like a perfect career for an impulsive person. It’s all about instinct, about acting on your hunches, about pulling the trigger and seeing what happens. Right? Uh, no. To be a good day trader, you have to trust your trading system more than your hunches. Sometimes you’ll make trades when it doesn’t seem right and you’ll sit out periods even though you are itching to get in. Good day traders are quick thinkers, but they do think. If you like to act now and deal with the consequences later, then day trading isn’t a good idea for you. 8. You love going to the casino Do you get a big rush out of gambling? Do you love trying to beat the odds? Does day trading seem just like a visit to Vegas without the airfare? Then you shouldn’t be day trading. Unlike at a casino, no one is going to give you free drinks or Celine Dion tickets in exchange for your massive losses. A lot of traders like to gamble. Every trader has some crazy story about playing Liar’s Poker using the serial numbers on dollar bills instead of with cards, or about a friend of a friend who bet on whether the person walking in front of him would turn right or left. And that’s fine, if they keep their gambling in perspective and bet no more than they can afford to lose. Trading isn’t necessarily gambling, but it can be, especially if you get carried away with the market and don’t stick to your trading and money-management systems. But remember this: In gambling, the odds always favor the house. When you cross the line, you hand your profit potential over to someone else. The line between day trading and gambling is thin. Check out these questions to see whether you may have a gambling problem. Substitute day trading for gambling and see what you come up with. And by all means, get help if you have a problem. Don’t take up day trading. 9. You have trouble setting boundaries Successful day traders are disciplined. They have set trading hours that they stick to and set systems they use to plan trades and manage their money. They took the time to carefully test their trading strategy. They understand that if they don’t have a system and manage their risk, they are more likely to become one of those numerous day traders who lose everything early on. The whole idea behind day trading is that you limit risk by closing out your positions at the end of the day. The financial markets are global, though, so in theory, the trading day never ends. If you have a hard time turning off the lights at the end of the day, you may not be the best day trader. If you resent rules, you may rebel against the rules that you’ve set for yourself. Good day traders know that they are cut out for day trading before they even begin. They’ve taken the time to assess how their personality and psychological makeup mix with the demands of the job. And one key trait is discipline. 10. You want to get rich quick Day traders look for short-term profit opportunities, so it follows that day trading leads to big, fast profits, right? Wrong. Day traders make money by collecting a large number of small profits. Those who make money usually do it through patience and persistence. Yeah, one or two day traders out there may have managed to make a killing in a week, but they’re the exception. Research shows that 80 percent of day traders lose their capital and are gone from the business within one year. Instead of getting rich, you are more likely to go broke quick from day trading. If you don’t like those odds, try something else with your money. 11. The guy on YouTube said it would work A lot of money can be made in day trading, but sometimes it seems like more money is made selling day trading training systems. Some of these systems are heavily marketed online and even through television infomercials. The sales pitch makes day trading seem like an easy, safe, fun way to make money using your own smarts. These commercials leave out pesky details about researching and testing systems, high levels of risk, and the pressure trading can place on a person. Day trading is great for some people. But like anything, if it sounds too good to be true, it probably is. Don’t let a strong-arm sales pitch cost you your hard-earned money.

Article / Updated 08-13-2019

Day trading is a cousin to both investing and gambling, but it isn’t the same as either. Day trading involves quick reactions to the markets, not a long-term consideration of all the factors that can drive an investment. It works with odds in your favor, or at least that are even, rather than with odds that are against you. Still, the three activities overlap. Many day traders also invest, and some came to trading after years of watching the markets as an investor. In addition, more than one day trader claims that good poker skills are useful for understanding market psychology, and many day traders can point to a winning trade that was made for no particular reason at all. To help you keep straight the differences between day trading, investing, and gambling, this article explains which is which so that you can better understand what you’re doing when you day trade. After all, you can increase your chances of success if you stick to the business at hand. Investing is slow and steady Investing is the process of putting money at risk in order to get a return. It’s the raw material of capitalism. It’s the way that businesses get started, roads get built, and explorations get financed. It’s how our economy matches people who have more money than they need, at least during part of their lives, with people who need it in order to grow society’s capabilities. Investing is heady stuff. And it’s very much focused on the long term. Good investors do a lot of research before committing their money because they know that it will take a long time to see a payoff. That’s okay with them. Investors often invest in things that are out of favor, because they know that, with time, others will recognize the value and respond in kind. In the long run, investing is a positive-sum game; on average, investors will make money, the only question is how much. One of the best investors of all time is Warren Buffett, chief executive officer of Berkshire Hathaway. His annual letters to shareholders offer great insight and are a great introduction to the work that goes into choosing and managing investments. What’s the difference between investing and saving? When you save, you take no risk. Your compensation is low; it’s just enough to cover the time value of money. Generally, the return on savings equals inflation and no more. In fact, a lot of banks pay a lot less than the inflation rate on a federally insured savings account, meaning that you’re paying the bank to use your money. In contrast to investing, day trading moves fast. Day traders react only to what’s on the screen. There’s no time to do research, and the market is always right when you’re day trading. You don’t have two months or two years to wait for the fundamentals to work out and the rest of Wall Street to see how smart you were. You have today. And if you can’t live with that, you shouldn’t be day trading. Trading works fast Trading is the act of buying and selling securities. All investors trade, because they need to buy and sell their investments. But to investors, trading is a rare transaction, and they get more value from finding a good opportunity, buying it cheap, and selling it at a much higher price sometime in the future. But traders are not investors. Traders look to take advantage of short-term price discrepancies in the market. In general, they don’t take a lot of risk on each trade, so they don’t get a lot of return on each trade, either. Traders act quickly. They look at what the market is telling them and then respond. They know that many of their trades won’t work out, but as long as they measure proper risk versus reward, they’ll be okay. They don’t do a lot of in-depth research on the securities they trade, but they know the normal price and volume patterns well enough that they can recognize potential profit opportunities. Trading keeps markets efficient because it creates the short-term supply and demand that eliminates small price discrepancies. It also creates a lot of stress for traders, who must react in the here and now. Traders give up the luxury of time in exchange for a quick profit. Speculation is related to trading in that it often involves short-term transactions. Speculators take risks, assuming a much greater return than may be expected, and a lot of what-ifs may have to be satisfied for the transaction to pay off. Many speculators hedge their risks with other securities, such as options or futures. Gambling is nothing more than luck A gambler puts up money in the hopes of a payoff if a random event occurs. The odds are always against the gambler and in favor of the house, but people like to gamble because they like to hope that, if they hit it lucky, their return will be as large as their loss is likely. It’s a zero-sum game with one big winner – the house – and a whole bunch of losers. Some gamblers believe that the odds can be beaten, but they are wrong. (Certain card games are more games of skill than gambling, assuming you can find a casino that plays under standard rules. Yeah, you can count cards when playing blackjack with your friends, but doing so is a lot harder in a professionally run casino.) They get excited about the potential for a big win and get caught up in the glamour of the casino, and soon the odds go to work and drain away their stakes. There is some evidence that day traders are gamblers. For example, in 2016, some researchers at the University of Adelaide published the paper “Day Traders in South Australia: Similarities and Differences with Traditional Gamblers.” They found that almost 91% of the day traders in their survey were also gamblers, and that 7.6% of those also had a problem with gambling, significantly higher than among people who were not day traders. The authors concluded that many day traders are actually gamblers who have added the financial markets to the games that they play. Trading is not gambling, but traders who aren’t paying attention to their strategy and its performance can cross over into gambling. They can view the blips on their computer screen as a game. They can start making trades without any regard for the risk and return characteristics. They can start believing that how they do things affects the trade. And pretty soon, they’re using the securities market as a giant casino, using trading techniques that have odds as bad as any slot machine. If you lose money day trading, you won’t get free drinks or comped tickets to the Celine Dion show in Vegas. See Casino Gambling For Dummies Cheat Sheet.

Article / Updated 08-13-2019

Day trading is a great career option for the right person in the right circumstances. It requires a strong, decisive personality who wants to be running the show every step of the way. And because those profits aren’t steady, good day traders have some financial cushion and good personal support systems to get them through the tough times. You love being independent Day trading is like owning any small business. You’re the boss and you call the shots. Each day’s successes — and failures — are due to you and you alone. The market is irrelevant because you can’t control it. Working by yourself all day, you’re responsible for everything from the temperature in the office to the functioning of the computers to the accounting for trades. Good day traders are independent. They don’t want someone to tell them what to do; they want to figure it out for themselves. They love a challenge, whether it’s finding a good bargain on office supplies or developing a profitable way to arbitrage currency prices. If you would like to work for yourself and control your own destiny, keep reading. Day trading may be for you. You want to work anywhere you like As a day trader, you have the luxury of setting up shop wherever you please. All you need is an account with an online brokerage firm and high-speed Internet access. You don’t even need a computer if you have a smart phone. Nowadays you can find these tools almost anywhere: at home, at the library, in a bar, in a big city, in a small town, in the mountains, or in another country. Day trading offers a lot of geographic flexibility, which few other businesses do. You can trade while traveling as easily as you would trade at home — especially with improved mobile services. You’re comfortable with technology The financial-services industry was one of the first to embrace computer technology in a big way, back in the 1960s, and it is still a technology-intensive industry. The people in colored cotton jackets running around the exchange floor, waving their hands and yelling at each other, are anachronisms. Day traders use software to develop and refine their trading strategies. They trade online using programs to monitor and automate their trades. They track their trades in spreadsheets and other software. They spend their days in front of a screen, communicating online with other traders all over the world. They interact with computers, not human beings, during the trading day. In fact, many successful day traders automate their trading — programming skills can be a big help. Day traders are also self-employed, and many work from home. That means that if their software crashes, they have to fix it. They have to handle the upgrades, install the firewalls, and back up the data. Sure, you can pay someone to do these tasks, but the tech consultant probably won’t be able to drop everything to get you up and trading again immediately. Hence, good day traders are comfortable with technology. If you like to mess around with programs, don’t mind maintaining your computer, and understand how to set up your hardware for maximum efficiency, you’re in good shape for day trading. You want to eat what you kill You don’t have to be a self-employed day trader to trade securities. Brokerage firms, hedge funds, and exchange traders employ people to trade for them. In fact, most securities trading takes place through such larger organizations. But maybe you don’t want to share your profits with someone else. Maybe you don’t want someone dictating your strategy, placing limits on your trades, or determining your bonus based as much on factors such as teamwork and firm profitability as on what you brought in. You want to “eat what you kill,” as they say, and day trading is one way you can do that. When you day trade, you’re responsible for your profits and your losses. That means that you reap the rewards and you don’t have to share them with anyone else. It’s a powerful incentive for independent people. You love the markets Good day traders have always been fascinated with the markets and how they move. If you watch CNBC for fun and have been following the securities business for years, no matter what your day jobs have been, then you may be a good candidate for day trading. Of course, I hope you’ve picked up more than “some people make a lot of money doing this!” A lengthy immersion in the cycles and systems that drive securities prices can help you develop trading strategies and know what you are up against. And the markets are amazing, aren’t they? All the buyers and sellers with all their different needs come together and find the price that gets the deal done. The prices assimilate all kinds of information about the state of the world, the desires of the people trading, and the future expectations for the economy. It’s capitalism in its purest form, and watching how it works is almost magical. If you love how the markets work and want to learn first-hand what they tell you about making money, then by all means keep reading. You have market experience If you have never opened an account with a brokerage firm, purchased a stock, or invested in a mutual fund, you may not be suited for day trading. It’s not that those activities alone are adequate preparation for day trading, but they’re a start. They can help you understand all that can happen to cause you to make or lose money. You’ve studied trading systems and know what works for you Much of the work of day trading takes place long before entering the buy or sell order. You have to define your trading system, see how it would have worked in the past, and test it to see how it works now. The preparatory work isn’t as exciting as actually doing the day trading, because you aren’t making real money, but you’re not losing money, either. Short-term trading has a huge potential for loss, and many traders are chasing the exact same ideas. The more you know about how your strategy works in different market conditions, the better prepared you will be to act appropriately and profitably. It can take a long time to find a strategy that works enough of the time to make it worth your while. Many day traders spend months developing, testing, and refining their day trading strategy. Because backtesting (which lets you test your trading strategy) uses historic prices, you can do much of the work on the side, at night, and on weekends, before you start day trading full time. It’s a good way to get prepared for your trading business while you save your money and make other preparations for your new day trading venture. You’re decisive and persistent Short-term traders don’t have the luxury of thinking too much about what they’re doing. Trading has to become intuitive. They have to be able to act on what they see when they see it. There’s no room for second guessing, for hesitation, for choking, or for panic attacks. Good day traders are also persistent. After they find a strategy they trust, they stick with it no matter how things are going. That’s how they’re able to buy low and sell high. Even great traders go through bad periods, but if they trust their system and continue to stick with it, they usually pull out of the bad period, often with money ahead. If you’ve been able to stick it out when things went wrong other times in your life, you know what to expect when day trading. You can afford to lose money Obviously, you want to make money. That’s the whole idea of day trading. But day trading is difficult. Most traders quit in the first year. Some can’t take the stress, some lose all their money, and some simply don’t make enough money to make it worth their time. Like any small business, you’re taking a risk when you set up shop as a day trader. That risk is easier if you can afford to lose money. I’m not saying you need to have so much money that you won’t miss it when it’s gone, but you shouldn’t be day trading with money you need to live on, any more than you would open a store or start a law practice with money you need to buy groceries and pay the mortgage. If your household does not have a second source of income, be sure to set aside enough money to cover your living expenses while you get started. And you should keep a second pot of money, your walk-away fund, so that you’re free to quit day trading and move on to your next adventure if you decide it’s not for you. It’s especially important to have a financial cushion when you’re day trading for the following reasons: You can afford to commit to your trading: Having your living expenses covered, at least at first, isn’t just about dealing with losses. It’s also about being able to stick with your trading. If you need cash to pay your bills, you may be tempted to take money out of the market whenever you’re doing well. Doing so may keep you from reinvesting your profits. Plus, by not sticking to your strategy, your trading capital won’t grow as fast. Think of day trading as a way to build a long-term asset, not a way to generate a steady stream of current income. You can stay in the market through the rough times: You know the old saying that the best way to make money is to buy low and sell high, right? Well, this means that the best time to buy is usually when securities prices have been beaten up and you’ve lost a lot of money. If you can afford some losses, staying in the game will be easier. Plus, you’ll be able to stick to your strategy so that you can profit big when the market finally turns. You can better handle the stress of losses: Not all your trades are going to work out. Some days, you’re going to lose money. If you have enough money that you don’t fear loss, you can make better decisions. And you’re less likely to panic if you know that you’ll still be able to eat, pay your electric bill, and have a roof to sleep under at night. With sufficient funds, you’re better able to view the markets clearly and follow a winning strategy. Trading is very much a game of psychology. Give yourself an edge by waiting to do it until you can afford to. You have a support system Trading is stressful. The markets gyrate from events that no one can foresee. Things just happen, and no one else who’s trading cares how these events affect you. It’s enough to make you crazy some days, and unfortunately, some traders do get crazy. Alcoholism, depression, divorce, and suicide seem to be occupational hazards for those traders who have trouble separating what’s happening in the market with who they are as people. The securities markets are wonderful mechanisms for bringing together diverse buyers and sellers. They are not wonderful for propping up your ego, helping you through a rough time in your life, or slipping you a little extra money when you most need it. The markets are not human. They are ruthless machines designed to generate the best price for the aggregate of the buyers and sellers participating that day. Some days, the markets will be in your favor, and some days, they will go against you. Good day traders are psychologically strong. They understand how their weaknesses come out when they are stressed. They have people (good friends and supportive families) and activities (from exercise routines to hobbies) that help give their brains a break from trading.

Article / Updated 08-12-2019

The key to success in day trading is discipline. That starts with good money management: determining how much money you will trade, when you will cut your losses, and when you will walk away with money in your pocket. If you don’t manage your money, you won’t be trading long. Here, you get an overview of the key money-management techniques that you should consider as well as one that is a very bad idea. Some of these techniques are simple; no calculation is required, and you can use them right away. Others involve a little workout with your calculator. A few of these techniques need your performance history to work, so you can’t use them right away, but you can experiment with them as you build your trade data. (And yes, this is one of the many reasons that traders should keep records of trading activity.) These days, many brokers include money-management calculators and apps in their trading systems, so you can enter the parameters that reflect your trading style and your account balance to get the right amount to trade, right away. These calculators remove the guesswork and mystery associated with some of these techniques — if you use them. Taking money off the table Here’s the simplest form of money management: When you’re up, take the profit rather than waiting to make even more money. Fight the greed, take the cash, and call it a day. If you have a week, month, or year with particularly strong profits, take a little money out of your trading account and put it in a retirement fund, use it to pay off a debt, or move it into a low-risk investment to help diversify your high-risk trading activities. Even if you do nothing else, taking profits when you have them can help keep you in the game longer. Using stops Unless you’re a machine, staying disciplined all the time can be difficult. Humans do goofy things. That’s why there’s a simple way to force discipline on your trading to keep your losses from destroying your trading account: a stop order. A stop order, also called a stop-loss order, is an order to buy or sell a security as soon as it hits a given price, known as a stop price. The order sits dormant in the broker’s computer until the market price hits the stop, and then the order is executed. This automated action helps you lock in a profit or cut a loss. Some traders don’t like stops because on occasion one will be executed on a one-time down trade or while a stock is shooting up at price, causing them to leave some money on the table. However, stops are an easy way to force discipline into trading. They can help you manage your money with very little extra effort. Yes, some brokers charge an extra commission for a stop order. But it may be worth it. Applying Gann’s 10-percent rule The Gann money-management system is part of a complicated system of technical analysis used to identify good securities trades. The chart system is complex, but the money-management system is simple. The core of it is a limit on the money placed on any one trade to 10 percent of the account value, never more. The dollar value of that 10 percent goes up or down as the account value changes, but the 10 percent limit ensures that you always have some powder dry to stay in the market. Most traders who follow Gann’s 10 percent rule combine it with stops to limit losses. You can’t take advantage of a profitable opportunity if you have no money to trade. You can lose everything in your account if you let your losses run. Limiting your losses with the fixed fractional system The fixed fractional system is misnamed; it’s actually a range of fractions that determine how much of your trade capital to risk on any one trade. A larger fraction is allocated to less risky trades; a smaller fraction to more risky ones. To do the calculation, you need to know how much money you can lose on any one trade. The study needed to determine that amount can go a long way toward improving your trading without getting into the math. Fixed fractional takes the stop a step further; it helps you limit your losses and pick up more from your wins by considering how much to trade along with the potential value of losses and gains. Increasing returns with the fixed-ratio system The fixed-ratio system of money management is related to fixed fractional trade sizing. The key difference is that it looks at accumulated profit rather than total account size. (Accumulated profit is the value of the account less the capital that you put into it when you started trading.) This system was specifically designed for options and futures trading by Ryan Jones, a trader himself. The goal is to increase returns from winning trades and protect profits from losing ones. Following the Kelly criterion formula The Kelly criterion is based on some statistical work by mathematicians working at Bell Labs in the 1950s. They realized that it had applications to gambling, so they went to Las Vegas and made a lot of money at blackjack. I kid you not. The casinos changed the rules so that it no longer works at Vegas, but it does work in securities markets. What this formula does is ensure that you will never run out of money, so you will always be able to place yet one more trade. In the real world, of course, you can reach a point where you still have money but don’t have enough to place a trade. The equation looks at the percentage of trades that are expected to make money (W), the return from a winning trade, and the ratio of the average gain from a winning trade relative to the average loss of a losing trade (R). You may not be able to use the Kelly criterion until you have been trading long enough to amass data to use in the equation, but that’s okay — you have other choices here! The Kelly criterion often generates a trade size larger than many traders are willing to use. One alternative is a half Kelly trade, using half of the amount recommended by the equation. Figuring the amount to trade with Optimal F Optimal F is another money-management system that needs performance figures to generate an ideal trade size. It was developed by Ralph Vince, a trader, and it comes up with the ideal fraction of your account to trade based on your past performance. The calculation changes with every trade, so it’s usually done through a spreadsheet or an app. Measuring risk and sizing trades with Monte Carlo simulation The Monte Carlo simulation is another money-management system drawn from gambling. It’s used for risk management in many different businesses, including trading. You enter risk and return parameters into a computer program, and it tells you the likelihood of total loss and the optimal trade size. The system can’t account for every possible thing that can go wrong, and it requires a lot of computer power — even nowadays. That being said, many trading and brokerage platforms have Monte Carlo applications that can be used to help you measure risk and size trades. Taking a risk with the Martingale system Martingale is another simple money-management system, no calculator required. It’s popular with gamblers and traders alike. You start with a small amount per trade — you get to pick it yourself, but it should probably be less than 5 percent of your account value. If the trade works, your next trade should be the same amount. If the trade does not work, then you close it out and place double the amount (double down, as they say) on the next trade so that you win back the loss. That doesn’t work? Double again. After you have a winning trade, go back to the initial amount for your next trade. If you have to double down for a long series of trades, the money involved quickly grows: from $2,000, for example, to $4,000, $8,000, $16,000, $32,000, $64,000, and even $128,000 if you have six losing trades in a row. This is the problem. If you have an infinite amount of money, you will come out ahead using martingale. With martingale, you can run out of money before you have a trade that works. The method works best for aggressive traders with large accounts who start with small initial trades. It’s a risky money-management strategy, but it’s also far preferable to having no strategy at all. Throwing it to the fates Many traders have a logical problem with money management. If you have a sure thing, why shouldn’t you put all your money on it? If you know the next trade is going to be great, why should you close out the day with a balance decline? Ah, but your logic is colored green with greed. Few sure things are as sure as they seem. Lose on the sure thing, and you won’t be around for the next trade. Exceed your daily loss limit, and you’ll have even greater losses. The wise sage Bart Simpson once said that years of watching television taught him that miracles always happen to poor children on Christmas Eve. Knowledge of money management is more of a sure thing than believing that you will be the beneficiary of a miracle today.

Article / Updated 08-12-2019

In short — ha! — selling short means that you borrow a security and sell it in hopes of repaying the loan of the shares by buying back cheaper shares later on. Traditionally, investors and traders want to buy low and sell high. They buy a position in a security and then wait for the price to go up. This strategy isn’t a bad way to make money, especially because, if the country’s economy continues to grow even a little bit, businesses are going to grow and so are their stocks. But even in a good economy, some securities go down. The company may be mismanaged, it may sell a product that’s out of favor, or maybe it’s just having a string of bad days. For that matter, maybe it went up a little too much in price, and investors are now coming to their senses. In these situations, you can’t make money buying low and selling high. Instead, you need a way to reverse the situation. The solution? Selling short. In trading lingo, when you own something, you are considered to be long. When you sell it, especially if you do not already own it, you are considered to be short. You don’t have to be long before you go short. Most brokerage firms make selling short easy. As a day trader, you simply place an order to sell the stock, and the broker asks whether you’re selling shares that you own or selling short. If you place the order selling short, the brokerage firm goes about borrowing shares for you to sell. It loans the shares to your account and executes the sell order. You can’t sell short unless the brokerage firm is able to borrow the shares. Sometimes, so many people have sold a stock short that no shares are left to borrow. In that case, you have to find another stock or another strategy. When the shares are sold, you wait until the security goes down in price, and then you buy the shares in the market at a bargain. You then return these purchased shares to the broker to pay the loan, and you keep the difference between where you sold and where you bought — less interest, of course. You can earn interest on the money you receive for selling the stock, and investors who are active on the short side of the market figure this into their returns. However, day traders don’t hold on to their positions long enough to earn interest. The stock exchanges are in the business of helping companies raise money, so they have rules in place to help maintain an upward bias in the stock market. These rules can work against the short seller. The key regulation is what’s called the uptick rule, which means you can only sell a stock short when the last trade was a move up. You can’t short a stock that’s moving down. The figure shows how short selling works. The trader borrows 400 shares selling at $25 each and then sells them. If the stock goes down, she can buy back the shares at the lower price, making a tidy profit. If the stock stays flat, she loses money because the broker will charge her interest based on the value of the shares she borrowed. And if the stock price goes up, she not only loses money on the interest expense but also is out on her investment. The interest and fees that the broker charges those who borrow stock accrue to the broker, not to the person who actually owns the stock. In fact, the stock’s owner will probably never know that his shares were loaned out. Choosing shorts Investors — those people who do careful research and expect to be in their positions for months or even years — look for companies that have inflated expectations and are possibly fraudulent. Investors who work the short side of the market spend hours doing careful accounting research, looking for companies that are likely to go down in price some day. Day traders don’t care about accounting. They don’t have the time to wait for a short to work out. Instead, they look for stocks that go down in price for more mundane reasons, like more sellers than buyers in the next ten minutes. Most day traders who sell short simply reverse their long strategy. For example, some day traders like to buy stocks that have gone down for three days in a row, figuring that they’ll go up on the fourth day. They’ll also short stocks that have gone up three days in a row, figuring that they’ll go down on the fourth day. You don’t need a CPA to do that! Losing your shorts? Shorting stocks carries certain risks because a short sale is a bet on things going wrong. Because, in theory, there’s no limit on how much a stock can go up, there’s no limit on how much money a short seller can lose. Two traps in particular can get a short seller. The first is a short squeeze due to good news; the second is a concerted effort to hurt traders who are short. Squeeze my shorts With a short squeeze, a company that has been popular with a lot of short sellers has some good news that drives the stock price up. Or, maybe some other buyers simply drive up the price in order to force the shorts to sell, which is a common form of market manipulation. When the price goes up, short sellers lose money, and some may even have margin problems. And the original reason for going short may be proven to be wrong. Those who are short start buying the stock back to reduce their losses, but their increased demand drives the stock price even higher, causing even bigger losses for people who are still short. Ouch! Calling back the stock All is not sweetness and light in the world of short selling. Many market participants distrust those folks who are doing all the careful research, in part because they are often right. Company executives are often optimists who don’t like to hear bad news, and they blame short sellers for all that is wrong with their stock price. Meanwhile, some short sellers have been known to get impatient and start spreading ugly rumors if their sale isn’t making money. Many companies, brokers, and investors hate short sellers and try tactics to bust them. Sometimes they issue good news or spread rumors of good news to create a squeeze. Other times, they collectively ask holders of the stock to request that their brokerage firm not loan out their shares, which means that those who shorted the stock have to buy back and return the shares even if doing so makes no sense.

Article / Updated 03-26-2016

Hedge funds are expensive, for a variety of reasons. If a fund manager figures out a way to get an increased return for a given level of risk, he deserves to be paid for the value he creates. One reason hedge funds have become so popular is that money managers want to keep the money that they earn instead of getting bonuses only after they meet big corporate overhead. Face it — a good trader would rather keep his gains than share them with an overpaid CEO who doesn’t know a teenie from a tick. Almost all hedge fund managers receive two types of fees: management fees and performance fees. More than anything else, this business model, not the investment style, distinguishes hedge funds from other types of investments. A management fee is a fee that the fund manager receives each year for running the money in the fund. Usually set at 1 percent to 2 percent of assets in a fund, the management fee covers certain operating expenses, salaries for the fund manager and staff, and other costs of doing business. The fund pays other expenses in addition to the management fee, such as trading commissions and interest. For example, say a hedge fund has $100,000,000 in assets. It charges a 2-percent management fee, which is $2,000,000. The fund has an additional $1,750,000 in trading expenses and interest. The fund investors have to pay fees from the assets whether the fund makes money or bombs. Most hedge funds take a percentage of the profits as a performance fee — also called the incentive fee or sometimes the carry. The industry standard is 20 percent, although some funds take a bigger cut and some take less. You need to read the offering documents you receive from a fund to find out what the fund charges and whether the fund’s potential performance justifies the fee. If the fund loses money, the fund manager gets no performance fee. In most funds, the fund managers can’t collect performance fees after losing years until the funds’ assets return to their previous high levels, sometimes called the high-water marks.

Article / Updated 03-26-2016

You can sort hedge funds into two basic categories: absolute-return funds and directional funds. The hedge fund that you choose depends on your investment strategy. Absolute-return hedge funds as investments Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing. Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady. In truth, the label is just a matter of personal preference. An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. Hedge fund managers can use many different investment tools within an absolute-return strategy. Investing in directional hedge funds Directional funds are hedge funds that don’t hedge — at least not fully. Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that they take. Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund. Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get potential investors excited about hedge funds. A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns.

Article / Updated 03-26-2016

Maybe you like the idea of trading but you've decided that working for yourself making large numbers of short-term trades isn't exactly what you want to do. What options are left? This article puts forward several ideas for alternative activities that may better match your interests than day trading. They include other career options, different ways to invest your money, and entertainment that gives you the excitement of trading without the same amount of risk. Proprietary trading for an investment company or hedge fund Day trading is a solitary pursuit, and not everyone who wants to trade also wants to run his own business and work by himself all day. Good thing many companies need people to trade for them. Investment companies, brokerage firms, and hedge funds hire traders. These people are often known as prop traders, short for proprietary, and their job is to trade money for the firm's account. These traders may have to follow a set style, or they may be free to trade as they see fit. Prop traders don't keep all their profits, but they get a small salary, benefits, and a bonus that represents a generous cut of the money they make. Trading for an agricultural, energy, or commodities company The options and futures markets were developed to help commodity companies manage their income and expenses better. A lot has changed in modern finance, but the traditional customers for the traditional commodity products of corn, soybeans, and orange juice are still active, and they need people to trade for them. They are often more interested in hedging — using trading to reduce risk rather than increase return — than in trading to maximize return, but depending on market conditions and firm philosophies, they may be open to traders who want to take on risk. Joining an exchange Although floor trading is going away these days, membership in the exchanges is not. Even the exchanges with publicly traded shares (which are most of them these days) have opportunities for traders to join in the fun by selling trading privileges to those who really want to be close to the action. It's not cheap; for example, membership (also known as a seat) at the CME Group runs around $480,000 and requires background checks, financial statements, and licensing. Many exchanges allow you to lease a membership in order to have access to the floor and the electronic exchange at a lower cost, which currently runs about $1,900 per month at the CME Group. Traditional investing for your own account Rather than day trade, you may want to manage your own investment accounts during the day instead of having a regular job. You won't have the drama of day trading, and you won't need to focus your attention for hours on end. Instead, you'll be researching stocks and mutual funds, allocating your portfolio among several different assets, and tracking your tax liabilities. If you aren't sure where to start, consider picking up a copy of Investing For Dummies by Eric Tyson (Wiley). Joining an investment club To get some experience before taking on the risks and expenses of day trading full time, consider forming or joining an investment club, which is a group of people who want to learn more about investing. Club members pool small amounts of money, such as $50 a month, meet regularly, and learn about different types of securities, methods of research, and styles of trading. Taking a swing at swing trading Swing trading is a cross between day trading and longer-term investing. Instead of closing out their positions at the end of each day, swing traders may hold their positions for a few days or even weeks. It's a way to change the risk and return profile. Price changes can happen overnight when you're away from your computer monitors, but the luxury of time means that there are more opportunities for your position to work out. Gambling for the fun of it Sloppy day traders are often gamblers: They aren't following a strategy; they just like the rush and the expectation of the positive return. This means that they aren't always paying attention to the market, nor are they ready to commit to the discipline of spending days in front of a screen and evenings reviewing market activities. If you are more of a gambler than a trader — and assuming you are not a problem gambler — why not just set aside a portion of your spending money to take to the casino? (Don't gamble more money than you bring.) Play day-trading video games Want the excitement of day trading without the risk of losing your money and without putting your job on the line? Then try playing a day-trading video game. The Chicago Board Options Exchange has a free game called OptionQuest on its website that you can use to play at trading. The RapidSP day-trading simulator, which has a free evaluation version and a not-free full version, gives you all the excitement of day trading without risk to your capital and without the sales pitch. It's a low-cost, low-risk way to enjoy the day-trading experience. Trade in demo accounts If you're looking for a free way to try day trading in general, you can trade in demo accounts. Many brokerage firms allow prospective customers to start with a demonstration account, both to check out the broker's capabilities and to see whether day trading is right for the customer. Some brokers even run contests in which prospective traders trade paper accounts (that is, not real money) and the winners receive money for a real trading account. Sign up for a trading contest Each year, some prominent financial-media companies offer trading contests. People can sign up for them and manage a paper portfolio (investing or day trading), and the participant with the greatest return wins a cash prize. Two popular ones are the CNBC Million Dollar Portfolio Challenge and the Investopedia Stock Simulator.