by Robert Sales
(McGraw Hill, New York, 180 pages) $24.95
reviewed by Gregory Bresiger
Professional traders beware: Is someone eating your lunch? Is someone going
to eat your lunch?
These are the implied questions of this interesting book (which was written and published before some of the appeal of day trading waned along with the stock market). The book discusses the techniques used by semi-professionals' who are trading for their own accounts, bypassing the great trading firms.
So why should professional traders bother with this book?
How one survives in a more crowded business place is the biggest issue for many professionals in the Information Age, a time when entry into all kinds of business has been facilitated by the computer. Trading is no different. With ravenous investors looking to gobble up what used to be much bigger spreads, professionals should know who and what are these semi-professionals,' those who trade for themselves and are not associated with any big firms.
There is an old answer to the question of how one survives in a revolutionary time that still makes sense today: One studies what the other guy is doing. Whatever one's business, it's a good idea to know who is trying to eat your lunch. This book discusses in detail some of the new competitors of professional traders as well as their strategies. That's one good reason for at least looking at this book, which is authored by the editor of Electronic Trading Week.
Given the suspicions of regulators and some individual investors that Wall Street too often short changes the retail investor, professional traders should be preparing for many more kinds of traders in the coming years. In fact right now, notes the author on the first page of the book, there is a lot of competition: "full-time day traders who trade on behalf of their own accounts are currently responsible for between 17 and 18 percent of the combined daily volume of the Nasdaq and the New York Stock Exchange."
These semi-professionals – or direct access traders as the author calls them – are already a force that just threatens to become bigger and bigger. Using a Bear Stearns study as a source, Sales says that, "semi-professionals trading with their own capital make an average of 875,000 trades a day – or roughly 47 percent of all Internet stock trades – even though they comprise less than one percent of the total 12.5 million U.S. online stock trading accounts" (page 2).
Rise of ECNs
Fueling the rise of the direct access trader, Sales notes, is the emergence of the ECN, which "typically supply faster executions than market makers" (page 6). Citing a study by Celent Communications, Sales says that ECNs will execute about half of Nasdaq's total volume some two years from today. ECNs threaten to eat bigger lunches because they tend to provide greater liquidity and post better bids on Nasdaq Level II – the updating quote screen that shows all the top bids and offers for a stock – than many Nasdaq market makers.
Obviously, the era of the individual trader is here to stay. He can no more be banished than Luddites at the beginning of the Industrial Revolution could restore a rural lifestyle by destroying factories. Cyberspace, like the first factories, will continue to expand. However, the edge for first-rate professional traders will come from the quality of work; from avoiding money-losing experiences that this book documents.
Sales notes how many individual traders – despite months of pricey training – often make very expensive mistakes such as averaging down. Says one direct access trader: "You're thinking I'm smarter than the market. You just don't want to take the loss. You feel weak and vulnerable, and you can't steer up the courage to take the loss and walk away" (page 20).
Sound familiar? Here's another common trading flaw documented by this book – the inability of new traders to manage risk.
"Throughout the course of a trading day, you may need to adjust your risk parameters, depending on your current capital situation, the current market trend, and the intra-day trend for the stock you are looking to trade. Regardless of what is going on in the market, however, discipline is the key to successful risk management," Sales writes (page 52). And another error that many of your new competitors are making: They're holding positions overnight, taking great risks that losses will accrue because of rumors or unexpected news breaking before the market opens again.
The most dangerous times to trade, Sales says, are the open and the close. He quotes one trader as saying, "the open represents the greatest potential danger because that is when the largest price movements occur" (page 145). But taking a position home after the close is also dangerous. It is a particularly dangerous practice for a scalper, a trader who makes profits from holding assets just long enough to take advantage of arbitrage opportunities that arise from small price changes.
Not surprisingly, that trading industry gadfly, Harvey Houtkin of All-Tech Direct, is a proponent of scalping. He argues that those traders who do it shouldn't be branded as scalpers; they're providing a vital service. (This is a familiar and, I believe, legitimate argument. If one doesn't have tickets for a big game that one desperately wants to see, it is the scalper who provides a service that is available no where else.) Houtkin calls scalpers, "de facto market makers. I wouldn't call this scalping. Is a retail store scalping if they buy something wholesale and sell it retail. What you're doing is basically providing liquidity and getting paid for it," he says. "You're buying on the bid side and selling on the offer side, to the extent that you can, and you're also mixing in momentum techniques" (page 33). The key to defending Houtkin's position, I believe, is this: Scalpers, or whatever one wants to call them, lose as well as win. There is no guaranteed outcome. This is the ultimate fairness in scalping stocks or Yankee tickets.
A trader, the author notes, must figure out if he or she is a scalper, a momentum player or a position trader. This is so important because strategies change as one's role changes in the trading world.
"As you evolve, you must devise a trading plan that complements both your personality and your trading capital. And perhaps more significantly, you must implement a risk management scheme that gives you the discipline you need to get out of a position before your losses mount," Sales concludes his book, reminding the reader that, "A fool and his (or her) money are soon parted."
Good advice in a highly competitive business, a business in which so many people are looking to part you from your money and eat your lunch.
