A Practical Instruction to Day Trading

A Practical Introduction to Day Trading

A Practical Introduction to Day Trading By Don Charles

A Practical Introduction to Day Trading By Don Charles This book first published 2018 Cambridge Scholars Publishing Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Copyright © 2018 by Don Charles All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-5275-1599-0 ISBN (13): 978-1-5275-1599-4

TABLE OF CONTENTS Preface ........................................................................................................ ix Chapter One ................................................................................................. 1 General Introduction 1.0 Trading ............................................................................................. 1 1.1 Trading Styles .................................................................................. 2 1.2 Portfolio Allocation ......................................................................... 4 1.3 Profit Loss Ratios ............................................................................. 5 1.4 Book Objectives ............................................................................... 5 1.5 Outline of Book ............................................................................... 6 1.6 Summary Insight .............................................................................. 6 Chapter Two ................................................................................................ 7 Day Trading 2.0 Introduction...................................................................................... 7 2.1 Where Assets are Traded ................................................................. 7 2.1.1 The Forex Market .................................................................... 8 2.2 Day Trading ................................................................................... 10 2.3 Opening an Account ...................................................................... 13 2.4 Important Questions to Consider Before Trading .......................... 18 2.4.1 Types of Orders ..................................................................... 20 2.4.2 Level 1 and Level 2 data ....................................................... 22 2.5 How to Find Stocks to Trade ......................................................... 24 2.5.1 Stock Scanners ...................................................................... 25 2.6 Creating a Watch-List .................................................................... 27 2.6.1 Top-Down Analysis .............................................................. 27 2.6.2 Fundamental Analysis ........................................................... 28 2.6.3 Technical Analysis ................................................................ 32 2.7 Summary Insight ............................................................................ 32

vi Table of Contents Chapter Three ............................................................................................ 33 Technical Tools and Technical Analysis 3.0 Introduction .................................................................................... 33 3.1 Technical Analysis ......................................................................... 33 3.2 Candlesticks ................................................................................... 34 3.2.1 Heikin-Ashi Candlestick ....................................................... 38 3.3 Types of Markets ........................................................................... 38 3.4 Chart Patterns ................................................................................. 39 3.4.1 The Elliott Wave Theory ....................................................... 49 3.5 Oscillators ...................................................................................... 54 3.5.1 Momentum Oscillator ............................................................ 55 3.5.2 On-Balance-Volume .............................................................. 55 3.5.3 Relative Strength Index ......................................................... 55 3.5.4 Relatove Volume ................................................................... 56 3.5.5 Money Flow Index ................................................................ 56 3.5.6 Stochastic Oscillator .............................................................. 57 3.5.7 Fibonacci Retracement Levels .............................................. 58 3.5.8 Force Index ............................................................................ 60 3.6 Moving Averages ........................................................................... 62 3.6.1 Simple Moving Average ....................................................... 62 3.6.2 Exponentially Weighted Moving Average ............................ 65 3.6.3 Volume Weighted Moving Average ..................................... 66 3.6.4 Moving Average Convergence Divergence .......................... 66 3.7 Bollinger Bands: Another Technical Indicator .............................. 67 3.8 Linear Regression Models ............................................................. 68 3.9 Summary Insight ............................................................................ 76 Chapter Four .............................................................................................. 77 Trading Strategies 4.0 Introduction .................................................................................... 77 4.1 Trading Strategies .......................................................................... 77 4.1.1 Crossovers ............................................................................. 78 4.1.2 Moving Average Envelopes and Bollinger Bands ................. 82 4.1.3 Momentum ............................................................................ 82 4.1.4 Volatility Breakouts .............................................................. 84 4.1.5 Reversals ............................................................................... 84 4.1.6 Events Trading ...................................................................... 85 4.1.7 Heikin-Ashi ........................................................................... 88 4.1.8 Elliott Wave Based Trading .................................................. 88 4.2 Evaluating the Trading Strategy .................................................... 90 4.3 Summary Insight ............................................................................ 91

A Practical Introduction to Day Trading vii Chapter Five .............................................................................................. 93 Risk Management 5.0 Introduction .................................................................................... 94 5.1 Types of Risk ................................................................................. 94 5.1.1 Market Risk ........................................................................... 94 5.1.2 Liquidity Risk ........................................................................ 95 5.1.3 Concentration Risk ................................................................ 96 5.1.4 Credit Risk ............................................................................ 98 5.1.5 Inflation Risk ......................................................................... 99 5.2 When to open a Position ................................................................ 99 5.3 When to close a Position .............................................................. 100 5.4 Position Sizing and Balancing Risk ............................................. 104 5.5 Common Mistakes ....................................................................... 107 5.6 Summary Insight .......................................................................... 107 Chapter Six .............................................................................................. 109 The Average Trading Day and General Conclusion 6.0 Introduction .................................................................................. 109 6.1 Mechanical Trading Systems ....................................................... 109 6.2 The Average Trading Day for the Informed Stock Trader ........... 112 6.3 A Practical Mechanical Trading System for Trading Currencies ... 114 6.4 Trading Plan ................................................................................. 115 6.5 Conclusion ................................................................................... 116 References ............................................................................................... 119

PREFACE Many individuals enter financial markets with the objective to earn a profit from capitalizing on price fluctuations. However, many of these new traders lose their money in trading. The reason for this is often because these new traders lack any fundamental understanding of financial markets, they cannot interpret any data, and they have no strategy for trading. Trading on financial exchanges is really about deploying strategies to systematically generate gains, and managing risks to minimize losses. Indeed, successful traders do have objective strategies which they have proved to be effective in granting them more financial gains than financial loss. The purpose of this book is to help a potentially uninformed retail trader or inquisitive reader understand more about financial markets, and assist them in the acquisition of the technical skills required to profit from trading. This book is a beginner’s guide to trading. It focuses mainly on trades of stocks and currencies on Exchanges. While some of the analysis can be useful for other assets such as futures, commodities, and options, the analysis will not always be relevant for such markets. The first chapter of this book introduces the reader to some key concepts in the trading industry. The distinction is made between trading and investing. The second chapter introduces the reader to day trading. It informs the reader of the basic information that they need to know before they attempt to trade in any market. The third chapter introduces the reader to Technical Analysis. It informs how to interpret charts, and how to recognize patterns in asset prices. The fourth chapter considers some basic trading strategies which may be used by retail traders. The fifth chapter considers how a retail trader may manage risk. Finally, the sixth chapter concludes with a practical example of a trading strategy.

CHAPTER ONE GENERAL INTRODUCTION 1.0 Trading Trading is the practice of buying and selling assets over a short-term period. Assets here refer to any financial security, commodity, or currency that an economic agent purchased. Market participants that practice trading are referred to as traders. A distinction can be made between a retail trader and an institutional trader. A retail trader refers to a trader that trades independently for themselves. An institutional trader refers to a trader that is employed by a financial institution (for example a commercial bank, investment bank, or hedge fund) and perform trading activities as part of their job description. Trading is distinct from investing. Investing refers to the practice of purchasing assets with the objective of gradually growing wealth from the asset over a period of time. The market participant may purchase a range of assets1 , and hold the portfolio2 of assets over a period of time. While the price of the assets in the portfolio may fluctuate over time, the goal of the economic agent is to ride out the short-term price fluctuations and gradually earn a positive return3 over a period of time. Market participants that engage in the practice of investing are typically referred to as investors. While investors seek to earn a return, perhaps with a range of 5% to 15%, over a year, traders seek to make such returns over a much shorter time period, ranging from a day to a few weeks. Traders try to take advantage of short-term price fluctuations in assets. When they execute 1 Some of these assets may include stocks, bonds, mutual funds, exchange traded funds and other investment instruments. 2 A portfolio is a group of assets. 3 The return is the profit from an asset. It is gain (loss) from price increases (decreases) plus the gains from dividends if any are paid.

2 Chapter One trades, they try to buy assets and sell them just a few dollars or cents higher. However, the make large profits by trading large volumes of assets with each trade. Traders can be categorized basis upon their style of trading. The next section will explore different trading styles. 1.1 Trading Styles In summary, trading styles may be categorized into the following: x Position trading; x Swing trading; x Scalping; and x Day trading. Position trading is where the position is held by the economic agent for several weeks to several months. Position traders first try to identify trends4 in the price of assets. If they expect a bullish trend5 , then they would go long6 on the asset. If they detect a bearish trend, they may short sell7 the asset. Position traders may not necessarily try to forecast the future prices of the asset, rather they try to ride the ‘wave’ of the trend which has been firmly established, and benefit from the overall movement of a stock in a market. Position traders typically exit a position when the trend breaks. 4 Here a trend refers to a sustained movement in the price of an asset. 5 A bullish trend is an upward trend or upward price movement. The opposite of a bullish trend is a bearish trend. A bearish trend is a downward price movement. 6 Going long refers to buying an asset. 7 Short selling refers to where an economic agent has sold an asset that they do not own. In essence, they have borrowed the asset from their broker and sold it. However, eventually the economic agent would have to repurchase the asset, perhaps when it falls to a lower price, and return the asset to their broker. When the economic agent returns the asset to the broker, it is referred as a ‘cover’. It is important to note, the US Securities and Exchange Commission adopted a Short Sale Restriction (SSR) rule since February 2010 (US SEC 2016). Once this rule is activated, economic agents can only short sell the asset once the price is going up. This rule was devised in order to prevent crashes from occurring as a consequence of too many economic agents short selling an asset while its price is declining.

General Introduction 3 Swing trading is where a market participant holds a position for a few days, to a few weeks. Once the trader holds more than few weeks, it is called position trading. Swing trading is slower paced than day trading since the time frame for holding trades is longer. It is very important that a swing trader have a trading strategy, as stocks will be moving up and down, but they will not be always available to constantly monitor the market like a day trader. Scalping refers to where traders’ long (or short) assets, hold them for a few seconds or minutes then close the position. Scalpers try to exploit small moves in price by trading large volumes of the asset over a very short period of time. Scalpers try to take advantage of the volatility8 in the market. Day trading refers to the practice of buying and selling assets in the same day. Positions are not held overnight. All positions are closed within the same day. Day traders try to make profits by exploiting the volatility in an asset price in a day. Like scalpers, day traders profit by moving a large volume of stocks. Day traders’ trading interval is the active hours of a trading day, whereas scalpers’ trading intervals range from a few seconds to a few minutes. When a trader opens and closes their position on an asset from an account, it is referred as a round-trip. Under the Pattern Day Trade Rule, the Financial Industry Regulatory Authority (FINRA) only allows three (3) round-trips within a five (5) rolling day9 period. This rule only applies to margin accounts10. 11 8 Volatility here refers to the tendency of the price of an asset to fluctuate. 9 The five rolling days here refer to five consecutive trading days. 10 Margin accounts are the accounts held by the broker that allows the market participant to trade on credit. For instance, if the trader has deposited $45,000 in the account, if they are trading on margin, the broker may allow the trader to take trades up to $90,000. 11 According to the FINRA, any account that places four day trades or more, within in a five trading day period is permanently deemed to be a ‘pattern day trading’ (PDT) account. The FINRA mandates that pattern day trading accounts maintain a minimum daily equity balance of US $25,000. If the account balance falls below US $25,000, traders can only perform closing transactions only until the account balance is increased to US $25,000. The FINRA deems Non-Day Trading Account as any account that has never placed 4 trades within a 5-day period. Non-Day Trading Accounts are required to have an equity balance of at least US $5,000 (Trade Station 2016).

4 Chapter One Traders select their trading style based upon: the size of their trading account; their level of experience; the amount of time they are willing to dedicate to trading; and their risk tolerance12. 1.2 Portfolio Allocation Portfolio allocation is the process by which the market participant decides which assets should compose the portfolio. Two factors that influence portfolio allocation are the time horizon and risk tolerance. Time horizon refers to the age of the investor/ trader relative to their retirement. Generally, the longer the time horizon of an investor, the more risk their portfolio can bear. This is due to longer time periods provide more time for the investor to recover from losses. For example, assume an investor made a 25% loss in a portfolio this year. If that investor has a long time horizon, then they have several years to recover from such loss. The risk tolerance refers to how much risk that an investor/ trader is willing to take. Risk here is defined as the likelihood that an investment may earn a return lower than the expected return. However, the greater the returns from an investment deviates from its expected returns, the riskier the investment. In fact, the Risk-Return Tradeoff asserts that the returns from an investment can be increased by taking larger risks. Investors/ traders trying to make profits cannot eliminate all risks. Instead, they should try to find a balance between the desired return from their investment and the associated risks. The risk tolerance of each investor is influenced by their personality as some investors are willing to take more risks, with the goal of earning a profit, than others. Risk adverse investors with short horizon would prefer portfolios which have a high weight of income stocks13. On the other hand, investors with a long horizon may prefer a portfolio with a higher weight of growth 12 Risk tolerance refers to how much loss a trader/ investor is willing to risk while trading/ investing. 13 Income stocks are equities that pay regular dividends. The dividend of income stocks often increases over time (Reilly and Brown 2011).

General Introduction 5 stocks14. Moderate investors with moderate risk tolerance and time horizon may prefer a portfolio with a higher weight of value stocks15. 1.3 Profit Loss Ratios Many retail traders may trade ad-hoc, or they may go to forums and inquire about other market participants’ trades in order to mirror them. Such traders may fear that they may lose money, subsequently influencing their consistent search for the correct tool which can help them make accurate trades 100% of the time. Retail traders may be searching for the “Holy Grail”, the trading secret that would lead to instant profitability. Such search may be unjustified since it is possible for a trader to correct about the market direction only 50% of the time yet still be profitable. Traders should be mindful of profit to loss ratios. If a retail trader can successfully trade with a profit to loss ratio of at least 2:1 then they can be profitable even if they are only accurate about the direction of the market 50% of the time. Most traders who are unable to achieve financial success on financial markets do so because they are trading with a profit to loss ratio where the average size of their financial gain is less than the average size of their financial loss. They could have a profit to loss ratio of 1:2 or even worse. Such statistics may be a result of the retail trader holding losses too long, or closing profitable positions too early. Throughout the course of this book, consideration is given to various tools and analytical techniques which could result in the retail trader earning more financial gains than losses. 1.4 Book Objectives Trading has the potential to general large profits in a very short period of time. However, if an economic agent attempts to trade without first understanding certain fundamentals about trading, they may lose large amounts of money while trading. Moreover, they may incur losses without understanding why. 14 Growth stocks are equities of companies whose earnings are growing above the average market rate. Growth stocks rarely pay dividends since the companies reinvest their earnings (Reilly and Brown 2011; Levin and Wyzalek 2014). 15 Value stocks are equities that are trading at a price that is low relative to its fundamentals (Levin and Wyzalek 2014).

6 Chapter One The objective of this book is to teach a potential reader, which is lacking prior knowledge of finance, the relevant information about financial exchanges, and how to profit from day trading. This book seeks to provide a roadmap for the trader who desires to learn to trade from a systematic approach rather than based on ad-hoc decisions and emotions. A study of the guidelines presented herein will help identify and eliminate the causes of failure, such as a poor strategy, incorrect data interpretation, poor risk management, and improper strategy evaluation. 1.5 Outline of Book While several types of financial instruments are available on stock markets, this book focuses mainly on trading stocks and currencies. Chapter Two of this book will review basic concepts in trading. It addresses issues such as how to open an account, and how to identify stocks to trade. Chapter Three explores the technical tools used for trading. It reviews market conditions, candlesticks, and chart patterns. Chapter Four considers a number of strategies which can be used by a trader to earn a profit. This will be supplemented by the strategies which can be used to manage risk in Chapter Five. Chapter Six probes into the average trading day of the market participant, and presents a general conclusion. 1.6 Summary Insight This chapter reviewed the basic concepts of trading. First, this chapter makes the distinction between trading and investing. Moreover, it makes the distinction between day trading, scalping, swing trading, and investing. This chapter then outlines the general risk preferences of different economic agents, and their predilection for portfolio allocation. Chapter Two, the next chapter, investigates the basic fundamentals of day trading.

CHAPTER TWO DAY TRADING 2.0 Introduction Many different economic agents enter financial markets, and may trade financial assets with the objective of making a profit. An uninformed but interested economic agent may be unaware of how to begin the process to engage in day trading. This chapter outlines the process in which such economic agent may open an account to engage in day trading. It starts by outlining where assets are traded. Then, it explains the factors that the economic agent should consider before opening an account. This is followed by a review of how the economic agent may identify potential stocks to trade; and an overview of the different analysis techniques that the economic agent may consider. 2.1 Where Assets are Traded Stocks and other financial securities are traded on exchanges. An exchange is an organized market where securities, commodities, currencies, and derivatives are traded. Exchanges with a physical location are referred to as centralized markets or centralized exchanges. Exchanges that do not have a physical location are referred to as over-the-counter (OTC) markets. The top centralized exchanges in the world on the basis of market capitalization are the New York Stock Exchange (NYSE), the NASDAQ, the Tokyo Stock Exchange, the London Stock Exchange, and the Shanghai Stock Exchange. Within the Caribbean region, there are smaller centralized exchanges such as the Eastern Caribbean Securities Exchange (ECSE), the Barbados Stock Exchange, the Jamaica Stock Exchange, and the Trinidad and Tobago Stock Exchange (TTSE). The smaller exchanges tend to be less efficient than the exchanges in developed countries.

8 Chapter Two 2.1.1 The Forex Market The trade of foreign exchange, or forex, is considered as trade in an OTC market. This perception arises is due to the entire market being run electronically, within a network of banks, continuously over a 24-hour period. The forex market is attractive for trading for a number of reasons. They include: i) the large size of the market; ii) the high market liquidity; iii) low transaction costs; iv) the 24-hour market; and v) low barriers to entry. The forex market is the largest financial market in the entire world. In fact, the market capitalization of the forex market is approximately US$6 trillion a day (Nag and McGeever 2016), while the market capitalization of the NYSE, the largest exchange, is only US$45 billion a day (NYSE 2017). The forex market is so large that it is difficult for any one market participant to manipulate the market. In contrast, the stocks market is often manipulated by large participants. The forex market is highly liquid. This is advantageous to traders as it means that they can immediately buy or sell forex at the market price whenever they desire. There will always be someone at the market willing to take the other side of the trade. Thus, a trader will never be stuck in a position for a currency pair. A currency pair is the exchange rate or quotation for two currencies. For example, the Euro / United States dollar (EUR/USD), the United States dollar / Japan yen (USD/JPY), and the United Kingdom pound / United States dollar (GBP/USD) are currency pairs. It shows how much units of one country’s currency is traded for another country’s currency. The major, and most actively traded currency pairs are: EUR/USD, USD/CAD, AUD/USD, USD/JPY, GBP/USD, and USD/CHF. Several currency pairs for developing countries are considered minor currency pairs, or exotics. The high liquidity and competition on the forex market results in low spreads between bid and ask16. Such low spreads result in low transaction costs per trade. In fact, for a trading factor of 0.01, some brokers may 16 The bid price is the price that the market participant offers to purchase the asset. The ask is the price that the holder of an asset requests for the sale of the asset. The retail trader can sell an asset at the bid price, but purchases assets at the ask price.

Day Trading 9 charge a commission of only US $0.09 (9 cents). In contrast to the trading of stocks, some brokers may charge US$5 per trade. The forex market is open 24 hours a day as a result of the overlapping of the majour markets. The forex market has four major trading sessions: the Sydney session; the Tokyo session; the London session; and the New York session. Table 2.1 below outlines the time for the majour trading sessions. Table 2.1: Open and Close times for the Major Trading Sessions April – October Time Zone EDT GMT Sydney Open Sydney Close 6:00 PM 3:00 AM 10:00 PM 7:00 AM Tokyo Open Tokyo Close 7:00 PM 4:00 AM 11:00 PM 8:00 AM London Open London Close 3:00 AM 12:00 PM 7:00 AM 4:00 PM New York Open New York Close 8:00 AM 5:00 PM 12:00 PM 9:00 PM October – April Sydney Open Sydney Close 4:00 PM 1:00 AM 9:00 PM 6:00 AM Tokyo Open Tokyo Close 6:00 PM 3:00 AM 11:00 PM 8:00 AM London Open London Close 3:00 AM 12:00 PM 8:00 AM 5:00 PM New York Open New York Close 8:00 AM 5:00 PM 1:00 PM 10:00 PM There are low barriers to entry to trade on the forex market. In fact, a retail trader17 can open an account to trade forex with as low as US$100. However, for stocks, the minimum account size allowed by brokers is US$500. 17 A retail trader is a market participant that engages in the practice of trading financial assets. Throughout the course of this book, the terms “retail trader”, and “market participant” will be used interchangeably.

10 Chapter Two 2.2 Day Trading The objective of the day trader is to make money from small price movements in an asset. For simplicity, consider only stocks.18 Therefore, the day trader is trying to profit from small movements in the price of stocks. This can be done by trading large volumes of the stock or taking larger positions. These positions may be larger than what some economic agents may feel comfortable investing. However, the risk is managed since the position is held for a short period of time, a few minutes to a few hours, and the trader monitors the prices while holding their position. To put day trading in context, consider the following example. An economic agent can invest $20,000 in a mutual fund19 and earn perhaps a 5% return per annum. This works out to be just $1,000. However, a day trader could invest the same $20,000 by purchasing stocks in 1 day. If by the end of the day, when the closed the position they made a profit of 5%, then they would make $1,000 that day. Thus, if the economic agent continues trading the same volume, it is possible to make a profit way in excess of 5% in that year. A trader can find a stock whose price can move by at least 5% within a day. However, not all stocks in the market will experience such large price movements. In fact, it may be only stocks that a reacting to news that may experience such large price movements. In general, good news about a stock, and the company’s profits should cause a positive price movement. Contrastingly, bad news about a stock or a company’s profitability should cause a decline in the price of stocks. To illustrate how stocks respond to news, consider this real-life example. On April 1, 2016, Sky Solar Holdings’ stock SKYS had a very good performance. It increased by 88% in 1 day. Upon the examination of news at yahoo finance, it was revealed that Sky Solar Holdings reported 18 There are many different types of assets on financial markets. For instance, there are equities, fixed income securities, mutual funds, commodities, forex and derivatives. However, for the purposes of this book, only stocks are considered. 19 A mutual fund is a portfolio which is managed by a fund manager. Mutual funds are sold directly to consumers. Mutual funds are marked to market daily, allowing their price to change on a daily basis. However, they are relatively safe investments, allowing an economic agent to earn a modest return, while taking minimal risks (Investopedia 2017). Since mutual funds are managed by professionals, and individual with absolutely no knowledge of finance can safely earn a given return.

Day Trading 11 the news of good profits for 2014 and 2015. They stated, “Q4 2015 total revenue of $12.2 million, up 49% over Q4 2014.” (Global News Wire 2016). A more recent example can be seen by Pokemon Go. Following the release of Pokemon Go, Nintendo’s stock price almost doubled. On July 6, 2016, Nintendo’s stock (NTDOY) was US $17.63. By July 18, 2016, NTDOY peaked at US $37.37, a 111% increase (Yahoo Finance, 2016). This increase in the stock price was due to traders and investors anticipating Nintendo earning significant profits from its 33% ownership in the Pokemon Company, which controls the merchandising and licensing of the Pokemon franchise, and an estimated 5-10% equity in the game’s developer, Niantic (Colgan 2016). In the week of the 18th to 22nd July 2016, Nintendo announced that Pokemon Go will have only a “limited” effect on its profitability since the game has other equity holders (Charles 2016). Since then the stock price of Nintendo fell from US $37.37 on Monday July 18, 2016 to US $26.75 by Monday July 25, 2016, a 28% decline (Yahoo Finance 2016). Day traders should look for stocks whose prices can move at least 5% within one day. Given that there are thousands of stocks on stock markets, a day trader should utilize the correct tools on the market. Some of the tools that can be used include: x Stock Charts; x Stock Scanners; x Stock News; and x Chat Room (optional). Stock Charts are charts that display patterns and trends of stock prices. A trader should examine stock charts to determine which stocks should be traded. Stock Scanners are software that can scan the stock market to find potential stocks of interest. For instance, if a trader is interested in stocks that experienced at least a 5% price movement within the last 10 days, the trader can input such requirements in the scanner and provide only the stocks that meet the trader’s criteria.

12 Chapter Two Stock News provides information on companies. In other words, is a company’s stock has experienced a significant change in price, the stock news can be used to determine the reason for the price movement. Stock Chat rooms are private forums on the internet whereby members may discuss various issues regarding stocks. Members of the chat room may provide tips as to what stocks should be traded, what positions to take, and when to close certain positions. Each one of the aforementioned tools may cost as much as $100 a month. While some of the services are offered free, the best services usually incur a fee. While such costs may be discouraging to a potential new trade, a trader should consider the act of trading as a professional business. Like many other businesses, there is some operational costs involved in order to maintain operations. However, if these services can assist a trader to make well-informed decisions, and profitable trades then the cost of such information may be justified. In microeconomics, a firm may incur various costs in its operation. However, it would continue to produce up to the point where its marginal costs20 equate its marginal revenue21. In other words, once its marginal costs of production are less than its marginal revenue, it would produce. The firm would maximize its profit at the particular point where the additional revenue from production just equates the additional cost of producing. More simply expresses, if a trader incurs these costs to make trades, it is possible for the trade to generate profits that far exceed these costs. A new trader, with little or no experience in trading, should first practice paper trading before trading with real money. Ameritrade22, Trade 20 Marginal cost is the cost of producing one (1) additional unit of output. 21 Marginal revenue is the revenue from producing and selling one (1) additional unit of output. 22 Ameritrade paper trading system may be accessed through Investools. This is available via the following link https://toolbox.investools.com/portfolio/paperMoneyLanding.iedu#. If users attempt to download the program directly from Ameritrade, some traders may be blocked as Ameritrade requires users to register but it only allow US citizens or US residents to create accounts.

Day Trading 13 Station, Sure trader and Market Watch23 can be used to do this. A new trader can open a demo account in Ameritrade and trade with imaginary money. A new trader should also try to use free services for stock news and charts, and try to develop a working trading strategy before trading with real money. By doing this, the trader can eventually develop strategies with known success rates. It is important to note, most new traders that fail, do so because they have no proven trading strategy. In other words, they are trading based on a guess, and they have no statistics to show the percentage success rate of their trading strategy. A day trader should look for stocks whose prices can change by at least 5% within a few minutes. The average stock will not experience such large price movements within such a short period of time. Therefore, such stocks are trading at extremes. 2.3 Opening an Account To commence day trading, a trader must first open an account with a broker. The trader must fill in their name, address, and other personal information with the broker. The fees of brokers vary. Table 2.2 provides a brief summary of the different fees of stockbrokers as of 2016. Table 2.2: Brokers, their Commission Fees and Minimum Account Sizes in the US Name Fee Minimum account size Scottrade US$7 commission per trade US$2,500 account minimum. ETRADE US$9.99 commission per trade US$500 account minimum. Fidelity US7.95 commission per trade US$2,500 account minimum. Trade Station US$4.99 commission per trade $5,000 Minimum for Non-Day-Trading Account. $30,000 for a Day Trading Account. 23 Market Watch account is not a real account. It is a demo which starts all players at $50,000 and charges a commission of $7 per trade. It is very easy to create a demo account at Market Watch. It is available at: http://www.marketwatch.com/game/

14 Chapter Two Speed trader US$4.49 commission per trade Light Speed US$4.00 per trade for 250 to 750 trades, plus accounts less than US$15,000 will be charged a US$25 monthly minimum commission fee US$25,000 is the minimum initial account size. Sure trader US$4.95 per trade up to 1000 shares $500 FX Choice US $0.09 per 0.01 trading factor $100 Before selecting a broker, a new trade should consider: 1. All the fees of the broker; 2. The minimum account size required by the broker; and 3. The online platform and the speed in which the broker execute trades. The trader should consider all fees. These include the commission fees per trade, plus possible hidden fees. For instance, Light Speed charges a fee of US$25 per month if the account size is less than US$15,000. Some brokers charge a fee for inactivity. For example, Sure Trader charges US$50 per quarter if there are less than 15 trades undertaken. Brokers typically charge additional fees for additional services. For instance, Speed Trade charges US$60 for international wire transfers. Some brokers have additional rules regarding transactions. For instance, if a trader uses Sure Trader as their broker, if the trader is using margin on Penny Stocks24, the account of the trader may be liquidated by Sure Trader. Consider an example where a retail trader may decide to open a daytrading account with a stockbroker. Assume that the commission per trade is US$5, therefore the commission per round trip is US$10. If the retail trader purchases one share of a stock at US$30 per share, the trader would need a positive price movement of US $10, or a cumulative effect of price movement and dividend payments of US$10 in order to break even. However, a US$10 price change is an approximate 33% change, which is considered large. If the trader desires to earn a profit from a smaller price movement they would need to compensate with volume. In other words, they will need to buy more than 1 share. For example, if the retail trader 24 Sure Trader refers to a Penny Stock as any stock below $3 (Sure Trader 2016).

Day Trading 15 bought 5 shares at US$30 each, (resulting in a total of US$150 for the long order), then the trader would only require a positive price movement of US$2 per share in order to break-even. In the case of forex trading, a retail trader may seek to profit from changes in the price interest points (pips). A pip measures the extent of change incurred in the exchange rate for a currency pair. For example, assume that the EUR/USD moves from 1.2250 to 1.2251. The 0.0001 change in the quotation is one pip. Alternatively expressed, a pip is 1/10,000 of a dollar. Just like stock trading, there are multiple brokers in the forex market. Some popular brokers include Ameritrade, Ally Invest, ATC Brokers, Forex.com, FX Choice, and Oanda. Table 2.3 provides an overview of the commissions and minimum account size for the aforementioned brokers. Table 2.3: Brokers, their Commission Fees and Minimum Account Sizes in the US Online Broker Commissions Account minimum FX Choice US$0.09 per trading factor of 0.01 $100 OANDA Both spread markup and commission ($50 per one million units) $0 Ameritrade Both spread markup and commission ($1 minimum; $0.10/1,000 units per side), depending on currency. $0 Forex.com Spread markup $50 Ally Invest Spread markup $500 ($3,000 recommended to trade full range of products) ATC Brokers $1 per 10,000 units, round turn $3,000 Source: Adapted from O'Shea and Royal (2018) FX Choice has a relatively cheap and simple commission system. FX Choice charges a commission of US$0.09 per trading factor. Additionally, this commission is only charged when an order is closed. So for a trading factor of 0.05, the commission would be US$0.45, for a trading factor of

16 Chapter Two 0.20 the commission would be US$1.80 and so on. Subsequently, even if the gain per dollar is a few cents, a retail trader can earn a profit from trading forex. Thus, a retail trader that is trading forex can operate a smaller account and be profitable than a retail trader that is trading stocks. It is noteworthy that the spreads for major currency pairs during normal trading periods on weekdays, (for e.g. at 9:30 am on a Monday) tend to range from 7 pips to 9 pips. Given the cost of commission of US$0.09 per trading factor of 0.01, a retail trader’s order would need to be in the correct position by 16 to 18 pips in order to break-even on a trade. The minimum account size is also important since if a trader does not have the minimum account requirements, they cannot use that broker to trade. For example, Fidelity minimum account size is US$2,500 for the trade of stocks. Whereas for forex trade, FX Choice minimum account size is US$100. Given the small account size mandatory requirement, and the small, yet proportional rate for the charging of commission, it is relatively easier for a retail trader to enter the forex market than the stock market. An important consideration is the requirements by the FINRA. Recall, FINRA mandates that pattern day trading accounts maintain a minimum equity of US$25,000, while non-pattern day trading accounts maintain a minimum equity of US$25,000. Since most day traders will undertake more than 3 round-trips within 5 consecutive trading days, then they will need to have an account balance in excess of US$25,000 in order to actively trade. However, Sure Trader, a broker based in Nassau, Bahamas, do not enforce the PDT restrictions of the FINRA. Subsequently, a trader with less than $25,000 may actively trade stocks on Sure Trader. It is important to note the disparity in the financial requirements for trading stocks and trading forex. For example, using a trading factor of 0.01, if there is a positive price movement by 118 pips (US 11.8 cents), a retail trader can generate a profit of US$1. In terms of the risk of that trade, then if there was a movement of 100 pips in the wrong direction the trader would stand to lose US$1.18. However, in the case of stocks, a trader buying 5 shares at US$30 each and hoping for a US$2 price increase would risk US$150 just to break-even. The online platform of a broker is also a factor to consider for trades. In the United States (US) and most exchanges in developed countries, the broker would provide an online platform that allows a trader to execute trades immediately. However, in exchanges in developing countries, there

Day Trading 17 may be no online platform. This is the case for brokers operating in the TTSE. The absence of an online platform, offered by brokers in a country, results in inefficiency in the exchange. In order to make a trade, a trader would most likely be required to go physically to the broker, fill out some forms, and exchange cash in order to make an order. Such conditions may result in little price movement in the stock market. In fact, for some stocks, there may be absolutely no trades and no price movement on some days. Inefficient markets may have wide spreads between the bid and ask. This may be problematic for a trader that desires to liquidate a large proportion of their assets suddenly, as they may be unable to acquire a buyer for their assets. This may result in the trader accepting a lower price than they desire for their assets. In stock exchanges in developed countries, there are typically Market Makers to facilitate liquidity in the market. Market Markers buy and sell assets, even when no one else is willing to trade the asset. In developing countries, there may not be a Market Maker on the exchange. It is important to note, all brokers will ask the account holder for the following information to create an account: x Contact Email address; x 2 Valid photo IDs (driver’s license, national ID, passport); x Bank account information; x Employer’s address and telephone number; and x Financial information (annual income, and total net worth). Some brokers have additional requirements for opening account. For instance, Sure Trader requires: x Financial and professional references; x Proof of residency (e.g. a utility bill, or bank statement, etc. no older than 6 months, with the account holder’s address); and x Non-US individuals are required to submit a W-8BEN form, NONUS Entities are required to submit a W-8BEN-E form, and for accounts that will be comprised of both non-US entities and individuals, will be required to submit a W-9 form.

18 Chapter Two 2.4 Important Questions to Consider Before Trading Before trading in any market, a trader should consider the following questions: x What types of financial markets are being considered for trading? x What is the trading strategy? o How are stocks selected? o What setups and scanners are used? o What strategy should be used? e.g. price crossover strategy; or a reversal trading strategy. o What are the statistics from paper trading on their strategy? o The time of day the trade was executed. What are the results of such trades? x What is the strategy for managing risk? o What is the profit-loss ratio? o What is the max loss ever experienced? o How frequently are losses made? What is the empirical probability of making losses? As previously mentioned, stock markets facilitate the trade of stocks, while forex markets facilities the trade of currency pairs. In stock markets, a retail trader needs to analyze and consider the dynamics of the stock market to inform their trades. The trader makes a profit from selling stocks at a price that is both higher than the purchase price of the stock and the cost of the commission to the broker. In the case of forex markets, a retail trader should focus their analysis on currency pairs and the factors affecting them to inform their trades. The forex market is advantageous and it allows retail traders with small accounts to trade on margin and earn profits from changes in pips. A pip is the smallest measure of change in a currency pair in the forex market. For instance, assume the price of a currency pair moved from US$1.259 to US$1.260. The change in price was US$0.001 or 1 pip.25 Brokers allow forex traders to place trading factors that are related to pips. A trading factor is analogous to a betting scale to determine how much of a retail trader’s capital is risked per trade. For example, at a trading factor of 0.01, a very small percentage of the retail trader’s account is risked with the trade. In fact, at a trading factor of 0.01, if a trade is in the correct position for 10 pips it would only result in a profit of 10 cents. However, if the 25 A pip is also 1/1000 of a dollar.

Day Trading 19 trading factor was 0.10, a trade is in the correct position for 10 pips would have resulted in a profit of US$1. Likewise, at a trading factor of 1.00, a trade in the correct position of only 10 pips would have resulted in a profit of US$10. It is noteworthy that while increasing the trading factor can increase the payout of each correct trade, it can also increase the loss of incorrect trade. Thus, traders need to mindful of how much capital they are risking with each trading factor if they don’t want to quickly diminish their account. While paper trading, new traders should document their strategies used, the times they were executed, and the profits made. Traders should document the actual ratio of profit to loss. As previously mentioned, an acceptable profit-loss ratio would be a 2:1 ratio or higher. In other words, even if the chosen strategy results in a trader earning a profit 50% of the time, and losing 50% of the time, the strategy would still be acceptable. Moreover, a higher profit to loss ratio implies that a trader can be wrong a lot, yet still make a lot of money. Retail traders also need to consider how they make decisions based on real time. Markets can move fast, and if a trader is slow in performing analysis, it is possible for them to miss profitable opportunities. Traders should also practice paper trading so they may become familiar with the trading platform of the broker. Experienced traders, can also practice paper trading so they may practice new strategies. Retail traders also need a strategy to manage their risks and losses. For instance, suppose the market moves in an unexpected unfavorable direction. The trader should have a limit on much loss they are willing to accept before they close the position. For example, if while holding an asset in the long position, the price of the asset declines unexpectedly by 30 cents, then the trader may decide to close the position in order to prevent the loss from growing. Retail traders need to manage their risk. For example, suppose a trader won 15 consecutive times, however, each time they won, they invested all of their earnings in the next trade. Then, whenever they incur the losing trade, they risk losing all their gains. In such instance, the trader would have a 15/16 (94% success rate), but the one time they lost, they risk losing all their earnings because they failed to properly manage their risks. Traders should only trade with real money when they have a strategy that has been proven to be profitable.

20 Chapter Two 2.4.1 Types of Orders While paper trading, the trader will have to make orders for stocks. A trade order is an instruction from a trader/ investor to a broker to enter or exit a position. Trades can be entered in different directions. Long orders refer to orders to purchase an asset. Short orders are orders to sell an asset. The direction of the order issued by the trader depends on their expectations of the market. If they expect the price of an asset to rise, they may issue long orders and they plan to buy the asset and resell at a higher price. If they are holding stocks and anticipate a decline in its price, they may issue a short order. If they anticipate a decline in the stock price but they don’t own the stock, they may issue a short order to short sell the stock. There are different types of orders, they include: x Market; x Limit; x Stop; x Conditional; and x Duration. A market order is an instruction to a broker to long or sell the asset at the market price. For instance, if the trader issues a long market order, then the broker will purchase the asset for the trader at the ask price26. Market orders tend to be filled immediately. However, the disadvantage of market orders is that they do not guarantee a price for the order to be filled. There can be slippage in price as market orders are filled. For example, assume a trader issued a market order to short 1,000 shares of a stock that they owned. This order is only filled by the broker finding other traders willing to purchase the stock. The first purchase order might be an order to purchase 500 shares at a price of US$20. Then, there may be a second order to purchase 300 shares at $19 per share. Then there might be a final order to purchase 200 shares at $18 per share. Although all 1,000 shares are sold, the average price the trader received was $19.3 per share.27 26 The ask price is the price the seller is asking for the asset. The ask price is distinct from the bid price. The bid price is the price the buyer is offering to pay for the asset. 27 ($20 x 500/1000)+(19 x 300/1000)+(18 x 200/1000) = 19.3

Day Trading 21 Due to the potential limitation of slippage, some traders may issue limit orders. Limit orders are orders which specify how much volume of an asset should be traded and at what price. Unlike a market order in which the trader sells a specified volume at the prevailing market price, in a limit order, the trader must specify the quantity of the asset that must be sold at a specific price. Traders use limit orders to protect themselves from sudden adverse movements in price. For example, a trader may issue a limit order to purchase 1,000 shares at $20. That guarantees all the shares purchased will be the same price. When the stock price rises to $26, the trader may issue a limit order to sell 1,000 shares at or above $26. However, the trader may issue a limit order to sell 1,000 shares if the stock price moves to $25. A stop order is an order to long or short assets only when they reach a particular price. Long stop orders are placed above the current market price, while short-stop orders are placed below the current market price. Once the asset’s price reaches the stop level, the order is automatically transformed to a market or limit order. Subsequently, stop orders are either stop market order or stop limit orders. A stop market order transforms into a market order once the stop level has been reached. Likewise, a stop limit order converts into a limit order once the stop level is reached. It is plausible to question, why would any economic agent want a stop order to purchase assets at prices above the current market price. However, a trader may issue a stop long order to purchase assets if they rise above a certain price. The trader may specify the stop price at a resistance price. Then once prices break resistance, it suggests that the market is becoming bullish, and subsequently, the trader could ride the trend. Likewise, in the case of a short-stop order, if stop price is at or below support, then once the stop price arrives, the market would have broken support. The trader could then ride the bearish trend to make a profit. Another application of stop orders can be seen with trailing stops. A trailing stop is a special stop order in which the stop limit is a percentage away from the current market price. The objective of any trader using a trailing stop is to protect gains. Trailing stops allow for a position to remain open when the prices are moving in the correct direction, but close if the price changes in the adverse direction by a particular percentage. A trailing stop can be explained by the following example. Assume a trader went long and bought a stock for $50, and placed a 15% trailing

22 Chapter Two stop order. Assume the stock price continues increasing. Then the order remains open. However, after peaking at $80, the stock price suddenly declines by 15% to $68. Then, at $68 the stop order will be activated to close the position. A trailing stop automatically tracks the asset’s price and does not have to be manually reset as in stop orders. Consider another example. Assume a trader decided to short sell an asset at $40 and placed a 5% trailing stop order to close the position. Assume the price of the asset declined by 10% to $36, then increased by 5% to $37.8. At $37.8, the stop order will activate and close the position. Conditional orders are orders that are automatically canceled or submitted if specific conditions are met. The main types of conditional orders are: order-cancel-order (OCO) and order-send-order (OSO). In OCO, a trader may enter multiple orders simultaneously. However, whenever one order is completely filled, the remaining orders are automatically canceled. An OSO is a primary order that will multiple secondary orders once the primary order is filled. Duration orders are orders that specify the duration of time in which an order remains on the market until it is canceled. The platform of the broker will determine duration times for orders. The duration can range from a few minutes to a day. Some brokers allow longer durations. 2.4.2 Level 1 and Level 2 data Once a trader has set up an account with the broker of their choice, they may proceed to the online platform to make an order. In the platform there should be: x A Market Depth (Level2) window; x A Time and Sales window; and x An Order Entry window. Some brokers may provide the three (3) aforementioned tools in the same window. Other brokers will provide the tools in separate windows. The Market Depth window displays the Level 1 prices. Level 1 indicates the bid and the ask price for an asset. It is also referred to as the National Best Bid and Best Offer (NBBO). However, level 1 data reveals on the surface of the market as it ignores trading volume. Level 2 data

Day Trading 23 shows the number of buyers associated with the bid price, and the number of sellers associated with the ask price. Traders are typically interested in Level 2 data as it indicates the demand and associated with their respective bid and ask prices. For instance, the Level 1 may show that the ask price for a stock is $20, while the bid price is $18. All a trader can discern from such Level 1 data is a $2 bid-ask spread. Upon inspection of Level 2, a trader may see that there are 50 people corresponding to the ask price, but there may only be 10 people that associated with the $18 bid price. In such a situation, the supply exceeds the demand. The free market economics would result in the price of the asset eventually decreasing closer to the bid price than the ask price. In addition to seeing the current amount of buyers and sellers at the current bid and ask price, Level 2 data also displays the number of buyers bidding below the current bid price, and the number of sellers above the current ask price. Level 2 data is very useful. It can indicate when a strong price trend is nearing its end, as its demand becomes weak. Or when a breakout28 is about to occur as demand for a stock significantly exceeds supply. However, Level 2 tricks can help large traders deceive smaller and more naïve traders. For instance, they can hide their order sizes by placing a series of small orders to prevent the tip-off of other traders. Alternatively, or conceal their actions through Electronic Communication Networks (ECN)29. By another token, market participants can engage in spoofing30 and manipulate the market by placing large orders to give a false sense of market direction. Due to the risk of Level 2 data, traders should perform additional analysis to determine if to long or short an asset. 28 Here, breakout means strong price action. It means a new uptrend or down trend. Breakouts will be discussed later in Chapter 3. 29 An ECN is a computerised system which obtains information on the best available bid and ask quotes from multiple market participants. It then matches and execute orders without going through a middleman. Orders placed on ECNs are typically limit orders (Investopedia 2017). 30 Spoofing is where large traders place large orders with the intent of sending false direction to manipulate the market.

24 Chapter Two The time and sales window display the transactions that occurred. It shows the number of time, the price and the number of shares that were traded when transactions were executed. The time and sales window can be used to support the Level 2 data. There is also a window to enter trades. This is where a market participant makes their order. The trader places the market or limit order in the trades window. Some traders may utilize hotkeys31 when entering trades. Hotkeys are relevant since the stock market is very volatile, and stock prices have been known to change their value by 100% or more in a few minutes. Thus, hotkeys allow traders to execute quick commands in order for a trader to capitalize on the quick price movements. 2.5 How to Find Stocks to Trade Some new traders choose stock by identifying the stocks of popular companies that they like, then entering a trade. However, it is highly unlikely that popular stocks will make large price movements in excess of 10% is a few minutes within a day. Stocks making such large price moves would typically be stocks that are under the radar and being influenced by news. Day traders typically focus on stocks which will experience high volume trade and large price movements due to news. There is a catalyst32 which is responsible for the stocks trading on high volume and prices. In order to find the stocks with the desired criteria, stock scanners can be used. Some free stocks scanners include: 1. Finviz; 2. Google Finance; 3. Yahoo Finance; 4. Market Watch; 5. Stock Twits; and 6. Trade Ideas. 31 A hot key is a key on a key board that allows a trade to execute a given command in the order window. They allow a trader to enter trades, exit trades, trade a percentage of their stocks, place limit orders, and cancel orders. The broker online platform might come with default hot keys to enter and exit trades. 32 The catalyst is an event, or something reported in the news which motivates traders to trade the stock.

Day Trading 25 2.5.1 Stock Scanners Finviz is a very user-friendly interface. On the home page, it will immediately present the stocks with the largest price movements. A user can search for specific stocks by their ticker, see their chart information, and review news regarding a stock. A user can also get information regarding the firm's Price Earnings (P/E) ratio, market capitalization, float, price and price change, sector, etc. The charts on Finviz are very useful as they utilize multiple moving averages and candlesticks. A trader can easily identify resistance, support, bearish and bullish trends based upon the chart information. If a trader pays US $24.96 a month, they can gain access to Finviz intraday charts.33 Google Finance has an interactive filter which can be used to stock stocks based on the criteria of the trader. Some of the criteria indicators include P/E ratio, market capitalization, and dividend yield. A trader can also customize their search and include other criteria pertaining to company valuation, dividends, financial ratios, operational metrics, stock metrics, etc. Google Finance can also be used to obtain news regarding stocks. Yahoo Finance is also an excellent free stock scanner. A trader can sort stocks by largest price gainer and losers, and largest movers. Yahoo finance provides historical daily prices on stocks, fixed income securities, currencies, benchmark indices, commodities, and mutual funds. Yahoo finance can also be used to access news regarding these financial assets. A user can also create a portfolio on Yahoo Finance, which may be used to keep track of specific assets. Market Watch provides an excellent, easy to use, stock scanner. It can filter stocks on the basis of price, volume, P/E ratio, and market capitalization. The scanner can also filter stocks outperforming their 50- day or 200-day moving averages, those outperforming a market index, and those traded on specific exchanges. Stock Twits can be used to both review historical stock prices and news regarding companies. Users of Stock Twits also post blogs about stock prices, their behavior, the reason for the price behavior, and potential future price movements. 33 The tools section will elaborate upon the different tools used to help make an informed decision regarding a trade.

26 Chapter Two Some analysts will use multiple stock scanners to identify stocks. For instance, some people might use Yahoo Finance to first identify stocks that are experiencing high price movement, then they will use Finviz to see the daily stock charts. Apart from stock scanners, traders can also identify possible stocks to trade by reviewing stock news. In fact, a good time to trade is after reading the economic calendar.34 Another good time to trade is during the reporting season. Bloomberg earning announcements35 will state when specific companies listed on the stock exchange will report their earnings. Consequently, a trader may visit Bloomberg, identify when the companies will report earnings and include these stocks in their watch-list. The trader may take a long position if good news is reported, and a short position if bad news regarding a company and its management is reported. Trade Ideas is a very good stock scanner. It allows traders to find patterns in real-time. Upon logging in, a trader can choose from a range of pre-configured scanning settings to identify stocks with bearish, bullish, or neutral trends. For example, if a trader is looking for stocks that are exhibiting a bull flag pattern, a trader can set the scanner to search for stocks that experienced a 5% price increase within the last hour, and the price has been fluctuating by 1% within the last 15 minutes. Or, a trader with a small account can search for stocks priced between $3 and $15. Or a trader can search for stocks with a market capitalization no greater than $100 million, and experience a 5% increase within the last 50 minutes. Or a trader can use the scanner before the market opens to find stocks with a low float36 and at least 10% of the float with pre-market orders. There is no limit to the different combinations of the stock scanner settings that a trader may employ. Trade Ideas provide chart windows, alert windows which stream and display events as they happen in real-time based on the filters selected. Trade Ideas also has an Odds Marker which uses probability to test inputted strategies in real time. Trade Ideas also has a free chat room. 34 Although the economic calendar is not a stock scanner, it provides excellent news about companies. 35 See http://www.bloomberg.com/apps/ecal?c=US 36 For the purposes of this book, low float stocks refer to stocks with 10 million or less in total share. Low float stocks typically refer to stocks with a relative small number of shares available for trade. Low float stocks have been identified as a preference for trade since it supply is limited, increases in demand may result in large changes in price.

Day Trading 27 Participants in the chat room may discuss trading strategies and potential assets to trade. While, Trade Ideas may cost US $99 per month, its services can be very valuable for an active day trader. Trade Ideas is recommended to any trader considering day trading with real money. However, for traders practicing with paper money, they may use free filters such as Finviz, Google Finance, and Yahoo Finance, as they seek to minimize their costs while learning how to trade. 2.6 Creating a Watch-List Day traders seek to trade stocks that are experiencing relatively high price movements. Such stocks may be trading in high volume and responding to news. Before purchasing any stock, it advisable for a trader to create a watch-list37. In fact, the trader may use stocks scanners to assist in their creation of a watch-list of a few stocks, and then apply analysis to the stocks to determine the correct entry position. There are several methods in which a watch-list may be systematically created. Some methods include: x Top-Down Analysis; x Fundamental Analysis; and x Technical Analysis. 2.6.1 Top-Down Analysis Top-Down Analysis refers to the technique whereby investors/ traders first consider searching for assets from broad categories, and then they gradually narrow down their search parameters. For example, an investor/ trader can begin by searching markets, then sectors, then industries, and finally individual companies. Top-Down Analysis is based on the premise that strong markets are comprised of companies with strong performing stocks. Subsequently, an investor/ trader can start exploring an industry and eventually filter out the strong companies. In Top-Down Analysis, an investor/ trader can begin by studying markets. Benchmark indices can be used to analyze markets. For example, 37 A watch-list is a list of stocks that a trader is considering buying or selling.

28 Chapter Two a trader may review the Standard and Poor’s (S&P) 500 Index38 to get insights about the general performance of stocks in the US. Because an entire market can be difficult to track, investors often use market indices as a benchmark for a market’s performance. For example, the U.S. stock market is commonly tracked by the Standard and Poor’s (S&P) 500® Index—an index comprised of 500 large U.S. companies. Other common indices are the Russell 200039, and the Dow Jones Industrial Average40. Markets can be disaggregated into sectors, for instance: the energy, the health, and the information technology sectors. Sectors can be further disaggregated into industries. For example, the health industry can be disaggregated into the pharmaceuticals industry, hospitals industry, residential care facilities industry, medical devices industry, etc. Finally, the trader can move from industries to considering individual stocks of companies. Traders can also perform bottom-up analysis. This is where they may begin with precise criteria for their stocks, they start with a small pool of stocks and analyze their performance relative to their industry, sector, and market. Top-Down Analysis is relevant for the trading of commodities, futures, stocks, and options. 2.6.2 Fundamental Analysis In Fundamental Analysis, a trader/ investor reviews the financial statements of a company to assess their financial strength and growth potential. Investors try to find companies with strong financial performance and growth potential In Fundamental Analysis, the trader is trying to determine: 38 The S&P 500 index reviews the performance of the 500 largest companies in the US. 39 The Russell 2000 index measures the performance of 2,000 small-cap companies that comprise the Russel 3000 index. The Russel 3000 index measure the performance of the largest traded stocks in the US, and is used as a benchmark of the performance of the entire US market. 40 The Dow measures the performance of the 30 most traded stocks on the New York Stock Exchange and the Nasdaq.

Day Trading 29 x Are the revenues of the company growing? x Is the company making profits? Are such profits/ loss growing? x Is the company performing better than other competitors in the industry? x Can the company repay its debts? The investor would be interested in information reported in balance sheets, income statements, and cash flow statements. From the balance sheet, an investor can compute a wide range of ratio. Some of the more popular ratios include the Quick Ratio41, the Current Ratio42, the Debt/Equity Ratio43, the Days Sales Outstanding (DSO)44, the Days Inventory Outstanding (DIO)45, the Days Payable Outstanding (DPO)46, the Cash Conversion Cycle47, and Inventory Turnover Ratios48. The Quick Ratio and the Current Ratio are Debt Ratios. The Quick Ratio measures a firm’s ability to cover its short-term debt obligations with its most liquid assets (like cash). The Current Ratio measure a firm’s ability to meet is short-term debt obligations with all its current assets. The Debt/Equity Ratio shows how a firm has financed its business operations. Generally, investors would be un-attracted to firms with high debt-to-equity ratios as it signals that the firm may have problems repaying their debt in the long run. The DSO, the DIO, and the DPO are all activity ratios measuring how effective a firm has been in converting its inventory into cash. The DSO shows how fast a firm is able to recover its accounts receivable. Firms with low DSOs recover their cash from accounts receivable quickly, while firms with high DSOs take a longer time to recover their cash from accounts receivable. 41 Quick Ratio = (Current Assets – Inventories) / Current Liabilities. Here assets refer to the things that have a monetary value that a company owns. Liabilities refer to things that companies use, have a monetary value, but the company do not own. 42Current Ratio = Current Assets / Current Liabilities 43 Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity. Note, there are also long term and short term Debt/ Equity Ratios. 44 The DSO = (Accounts Receivables / Revenue) x 365. 45 Days Inventory Outstanding = (Inventory / Cost of goods sold) x 365 46 Days Payable Outstanding = (Accounts Payable / Costs of goods sold) x 365 47 Cash Conversion Cycle = DIO + DSO – DPO 48 Inventory Turnover = Cost of goods sold / Average of Inventory

30 Chapter Two The DIO is a measurement of the average number of days a firm holds its inventory before selling it. The DPO shows the period of time a firm takes to repay its creditors for their factor inputs. The summation of the DSO, the DIO, and the DPO produces the Cash Conversion Cycle. It is a measure of the overall effectiveness of a company in converting factor inputs into cash. The Inventory Turnover Ratio measures the effectiveness of a company in selling goods. The lower the Inventory Turnover Ratio, the faster a company’s inventory is converted into sales. The Cash Flow Statement can be used to determine if a company has difficulty in covering its short-term financial objectives. The statement of cash flows can be used to compute a range of financial ratios such as the Operating Cash Flow/ Net Sales ratio; the Free Cash Flow/Operating Cash Flow Ratio, the Short Term Debt Coverage Ratio, and the Dividend Payout Ratio. Out of all the Cash Flow Statement ratios, the Dividend Payout Ratio is of the most interest to investors. It is given by the equation The ܦ݅ݒܽܲ݀݊݁݀݅ݐݑ݋ݕܴܽݐ݅݋ ൌ  ௗ௜௩௜ௗ௘௡ௗ௦௣௘௥௦௛௔௥௘ ௘௔௥௡௜௡௚௦௣௘௥௦௛௔௥௘ (2.01) This ratio is an indicator of the sustainability of dividends payments. Many investors are attracted to high dividends but will be disappointed if dividends dwindle in the future. Moreover, if dividends payments decline in the future, then there will be a high chance that the company’s stock price would decline. Furthermore, since dividends are paid in cash rather than in accounts receivable, investors may consider comparing the Dividends Payment Ratio of a company to its available cash to ensure its dividend payments are sustainable. The Income Statement can be used to assess the profitability of a firm. Thus an investor will be concerned with the revenues, costs, gross profits, net profits of the firm. The investor can extract information to compute certain ratios such as the gross margin, operating margin, earnings per share (EPS) and price-earnings (P/E) ratio. The EPS is given by ܧܽݎ݃݊݅݊ݏ݌݁ݎݏ݄ܽݎ ݁ൌ ௘௔௥௡௜௡௚௦௔௙௧௘௥௜௡௧௘௥௘௦௧௔௡ௗ௧௔௫௘௦ ௧௢௧௔௟௡௨௠௕௘௥௢௙௦௛௔௥௘௦௢௨௧௦௧௔௡ௗ௜௡௚ (2.02)

Day Trading 31 The P/E ratio is given by ௘௖௜௥௣௞௖௢௦௧  ൌ ݋݅ݐܽݎܧȀܲ ா௉ௌ (2.03) The Gross Margin is derived by dividing gross profit by net sales. The gross profit margin indicates how much money is available for reinvestment in the business after accounting for the cost of goods sold. Operating Margin is computed by dividing operating income by net sales. Operating margin indicates how much income is available after coveting paying variable costs such as wages and raw materials. The EPS is computed by dividing the net profit after interest and tax of the firm by the total number of shares. It provides insight as to how much earnings or profit goes to each shareholder of the company. Investors would prefer companies with higher or growing EPS can it suggests that the company average profits per shareholder increases over time. The P/E is the stock price divided by the EPS. The P/E ratio is a valuation ratio that provides an idea about the worth of a company. It also indicates how much money an investor must pay in order to receive $1 of annual earnings. For example, A P/E ratio of 50 means that investors are paying $50 in order to earn each $1 of investment. The EPS and P/E ratios are two popular financial ratios investors consider while investing. In the performance of Fundamental Analysis, the trader/ investor must also consider the larger economy. This is due to industry trends having a tendency to affect the profitability of firms. For instance, as a result of the shale revolution, and the oversupply of crude oil in the world market between 2014 and 2016, oil prices collapsed from the US $100 per barrel (bbl) range to the US $30 per bbl range. Consequently, firms in the crude oil industry would experience a decline in profitability. Indirectly, this would affect the service companies in the upstream oil industry as there would be an eventual decline in service requests from upstream oil companies. Thus the revenue and associated profitability of upstream service companies would decline due to a problem arising in the industry. It is important to note, Fundamental Analysis is relevant for stocks. It is not relevant for commodities, or forex.

32 Chapter Two 2.6.3 Technical Analysis Technical Analysis involves the study of the historical price of a stock as well as its volume. Price charts are used for technical analysis. Unlike Fundamental Analysis, Technical Analysis assumes that stock prices illustrate adequate information. Technical Analysis applies the principles of demand and supply to explain asset prices. For instance, an increase in the demand for stocks relative to their supply should lead to an increase in stock prices. Likewise, increase in the availability of the supply of a particular stock can lead to a reduction in the stock price. Note, Technical Analysis is relevant for stocks, commodities, forex, futures, and options. Technical Analysis can also be used to identify trends in asset prices. Various tools are used to confirm trends and forecast future trends. Once the market participant believes they have identified particular trends they can then develop a strategy to make a profit. Chapter Three will explore Technical Analysis and its corresponding tools in greater detail. 2.7 Summary Insight This chapter provided an introduction to day trading. New traders are encouraged to first create a paper account and trade with demo money before live trading with real money. In this way, they can trade when they are sure they have developed a strategy that has proven to be effective. New traders are encouraged to use free stock scanners such as Finviz and Yahoo Finance to identify potential stocks. However, Trade Ideas is recommended for traders utilizing live money as it can easily filter stocks by a wide range of both financial and technical criteria. Investors and traders can use multiple methods to identify stocks. In summary, the main methods include top-down analysis; fundamental analysis; and technical analysis. Each type of analysis has its strengths and weaknesses. However, this book will focus more on technical analysis as it is used heavily by traders and investors. Chapter Three will delve into technical tools and technical analysis in greater detail.

CHAPTER THREE TECHNICAL TOOLS AND TECHNICAL ANALYSIS 3.0 Introduction As previously mentioned in Chapter Two, economic agents may use three general techniques to create their watch-list. While Top-Down Analysis, and Fundamental Analysis can be useful for trading, this book focuses upon Technical Analysis. Top-Down Analysis, and Fundamental Analysis are more relevant for long-term decision making and investing. In trades, which may take place in less than a minute, the economic agent may not have sufficient time to perform Top-Down Analysis, and Fundamental Analysis. However, the univariate time series of an asset’s price may be sufficient for quick decision making. This chapter will explore Technical Analysis in greater detail. It considers important technical tools, namely: candlesticks, chart patterns, and oscillators. 3.1 Technical Analysis Technical Analysis can be disaggregated into two categories: the analysis of charts; and the analysis of indicators. Charts analysis involves the utilization of charts to analyze trends in stock prices. Indicators are essentially indices that can be used to analyze prices, volume, and volatility. Several types of charts can use used for analysis. Line charts, bar charts, and candlestick charts can all be used to analyze stock price patterns. However, the most powerful type of charts which can be used in trading is the candlestick charts.

34 Chapter Three 3.2 Candlesticks A candlestick is a chart that reflects the open price, closing price, highest price and lowest price of a stock, over a period.49 Figure 3.01 provides an illustration of a candlestick. Figure 3.01: Candlestick Source: Adapted from Nison (2001) The area in the candlestick between the open and the close price is referred to as the body. The lines extending above and below the body are referred to as shadows, wicks or tails. The shadow above the body is referred to as the upper body, while the shadow below the body is referred to as the lower shadow. If the stock closes at a price higher than the open price the body is colored white. If the stock closes at a price lower than the open price, the body is colored black. Candlesticks with longer bodies experienced more volume and price movement than candles with shorter bodies (Nison 2001). Many traders prefer candlestick charts to bar charts as candlestick charts display easy to decipher financial information. By viewing a candlestick a trader can easily see the open prices, closing prices, and possible patterns. For instance, if there are consecutive while candlesticks then it suggests buying pressure and possible bullish price movements. If 49 For daily charts, each candlestick represents the price movement taking place within a day. For intra-day charts, each candlestick can represent the time interval, e.g. 1 minute or 5 minute.

Technical Tools and Technical Analysis 35 there are consecutive black candlesticks, it suggests selling pressure and possible bearish price movements. See Figure 3.02. Figure 3.02: Candle Stick Chart vs a Bar Chart Source: Stock Charts (2016) Candlesticks with long white bodies suggest strong buying power. Whereas candlesticks with long black bodies suggest strong selling pressure. Candlesticks with long upper and lower shadows suggest that there were outliers or extremes in the prices within the trading period (Morris 2006). Candlesticks with long upper shadows and short lower shadows suggest that within the trading period, pricing moved significantly above the open price suggesting strong buying pressure within the trading period. However, there was some volatility in the prices resulting in the stock eventually closing at a price lower than the highest price within the trading period (Nison 2001).

36 Chapter Three Candlesticks with long lower shadows and short upper shadows suggest that within the trading period there was strong selling pressure resulting in the decline in the stock prices. However, some buying pressure resurfaced by the time the stock was ready to close resulting in the stock closing at a price higher than the lowest price. Figure 3.03 displays candlesticks with long and short shadows (Nison 2001). Figure 3.03: Candlesticks with long and short shadows Source: Adapted from Stock Charts (2016) Candlesticks possessing long upper and lower shadows, and short body are referred to as spinning tops. Spinning tops are neutral candlesticks and represent relative indecision within the trading period. In other words, there was almost equivalent buying and selling pressure during the period, causing the closing price to be very close to the open price (Morris 2006). Figure 3.04 illustrates two Spinning Top Candlesticks.

Technical Tools and Technical Analysis 37 Figure 3.04: Spinning Top Source: Adapted from Stock Charts (2016) Another type of neutral candlestick is a Doji. A doji is a candlestick in which the open price is almost equivalent to the close price. The length of the shadows of doji can vary resulting in the Doji appearing like a cross, and inverted cross, or a symmetric cross. Doji are very important in analysis, since they may suggest a turning point in trends (Morris 2006). Figure 3.05 displays different doji. Figure 3.05: Doji Source: Adapted from Stock Charts (2016) The criteria for confirming a doji can vary based upon the price of the asset. For example, a stock that was trading at $25 could have a doji with only a 1/8 price difference between the open and close price. However, another stock that typically trades in the $300 price range could form a doji with a 1 ¼ point differential between the open and the close price. To

38 Chapter Three confirm doji, a trader must consider the position of the doji relative to other candlesticks. For example, a doji that occurs among other candlesticks with small bodies may not be considered significant. However, a candlestick with a very small body that forms among other candlesticks with large bodies may be considered significant (Nison 2001). 3.2.1 Heikin-Ashi Candlestick Heikin-Ashi candlesticks visually appear similar to candlesticks. However, the prices on the Heikin-Ashi candlestick are computed differently. In fact, the prices of a Heikin-Ashi candlestick are computed from the price of the previous ordinary candlestick. x Open price: is the average of the open and close price of the previous ordinary candlestick. x Close price: is the average of open, close, high and low prices of the previous ordinary candlestick. x High price: is the highest open or close price from the previous candlestick. x Low price: is the lowest open or close price from the previous candlestick. Heikin-Ashi charts are slower than candlestick charts as their signals are delayed. Such delays eliminate a lot of noise and false signals. They may be used by traders in addition to candlesticks to confirm patterns. 3.3 Types of Markets Financial markets go through different phases. They can be categorized into the following: 1. Bull markets; 2. Bear markets; 3. Cycles; and 4. Congested. A bull market refers to a market on the rise. The price of assets in the market is increasing. Typical bull markets advance at a gradual pace, and can last for months or even years. A linear regression of typical bull markets will have a slope ranging between 150 and 500 .

Technical Tools and Technical Analysis 39 Roaring Bull Markets are bull markets with more extreme price progression. A linear regression of Roaring Bull Markets may have a slope ranging between 500 and 700 . Roaring Bull Markets occur less frequently than typical bull markets. Furthermore, roaring bull markets tend to be short-lived. A bear market is a market with a sustained price decline. Typical bear markets experience a gradual decline in the prices of assets. The slope of a linear regression of a typical bear market ranges between -150 and -400 . Panic Bear Markets are the extreme market condition variant of bear markets. They refer to markets that are experiencing rapid price decline. They tend to occur as the consequence of mass hysteria or a crash in financial markets. The Ordinary Least Squares (OLS) regression of panic bear market tends to have steep slopes ranging between -500 and -700 . The cyclic market, as its name implies, display cycles. It goes from a short bull to a short bear to another short bull. Or from a short bear to a short bull to another short bear. The congested market is characterized by an absence of a trend in asset price movement. Congested markets tend to display price fluctuations with no easily recognizable pattern. Congested markets may offer an opportunity for scalpers trying to make small profits. However, strategies designed for momentums or reversals may experience a drawdown. Given that the general market conditions have been identified, the next section will review chart patterns which in turn reveal the condition of the market. 3.4 Chart Patterns Candlesticks can be used to identify various trends in markets. A trend is a general direction in which the price of an asset is moving. Trends can vary both in duration and direction. While there are numerous statistical methodologies that can be used to extract trends from raw data, one of the more popular tools used by traders are trend lines. A trend line measures the reaction of investors to the volatility in stock prices. They are used by traders to determine the best time to enter and exit certain positions. When traders review raw data on stock prices, they will see the prices form peaks and troughs. Trend lines can indicate support levels and resistance levels. The troughs usually represent a low