The Business of Trading
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The Business of Trading
By Steve Goldman
Head Trader, Yamner & Co., Inc.
My exposure to a broad range of traders involves the overseeing, delegating and handling of our trading desk activities as well as my activities in educating the financial community. I personally work with clients that range from hedge funds, mutual funds and other institutions to position traders, daytraders and long term investors. And while each client/trader has different objectives, risk tolerances, time frames, capital commitments, etc., there are certain characteristics, which the most successful traders possess.
The most successful traders I have known approach their trading the same way that any entrepreneur or other businessperson would view their enterprise. The best traders engage in trading as professionals, employing rigid discipline and mainstream business concepts. To help traders best meet their financial objectives, I often suggest that they develop business plans, models from which they can focus their efforts. I have found this to be a critical component to success.
Mission statement – Every business plan has a mission statement to clarify objectives and goals. Simply stating that you want to make money in the financial markets is not acceptable. It is too vague. Traders need to clarify their objectives with detail. A more acceptable mission statement might be:
“Over the next 6 months, I will pursue a course of trading stocks with a typical holding period being one day, where I will strive for ½ point gains and strive to limit loses to no more than 3/8 of a point. I will work with a firm that permits me to place rigid stops on both listed and over-the-counter securities. I will commit $100,000 in principal and strive for a 35% percent return on investment. I will trade a mix of listed and over-the-counter stocks with a 40/60 ratio. I will evaluate my results each week, back-testing my strategies. I will hedge risk and maintain discipline at all costs, striving to preserve capital and capitalize on opportunities.”
Hours of Operation - Hours of operation are from 8am, if not earlier, until 5pm, evenings and weekends. I have known many traders who simply engage the markets from 9:20am until 4pm. This may be because they are over confident in their understanding of the markets or because they feel that over-analyzing the markets will pollute their intuitive skills at gauging short term market direction. While this approach is glamorous, it rarely meets with success.
The analogy is similar to a professional basketball player's ability to succeed without long hours of practicing, lifting weights and cardiovascular training. Few can succeed this way. My philosophy is to work tirelessly and efficiently. Good things will come.
While the payoff can be significant, trading is hard work. As in any business, success requires that you work harder and more skillfully than everyone else. You must learn the markets, the systems, the firms, and the stocks, inside and out. Trust me, there are some incredibly brilliant individuals out there that work relentlessly at their profession. They are there to beat you. If you feel deficient in any area, you must make it up by working harder than the rest. You must pursue every area of knowledge and become intimate with all the components that relate to the financial markets. Not only will this provide the mental stimuli necessary to ensure your contentment with your occupation, but will also help further your chances of success.
Investments in your company – As in any business, there are several key investments you must make to succeed as a trader. This is not to suggest that because of the potential for quick and substantial gains that traders can spend without limits. Cost efficiencies must be pursued, yet under-capitalization or insufficient resources can often be far more costly than overspending. Spending $125 for a premier offering amounts to simply needing to achieve a 1/8th point better on one 1000 share trade during the entire month.
As in any business, there are often many vendors available for the various resources needed by a company, from premier; elite offerings to more budget oriented choices. Given the large capital commitments in each trade, the following are critical investments:
1. Quote services
This is usually the most important element of traders' resources. Services can range from free, broker-provided, data feeds, to internet, fee-based quotes, to LAN-based and satellite systems. Costs for such services can range anywhere from $15 per month to over $350 per month. Many traders make the grave mistake of utilizing inferior quote services.
In an industry where the timeliness and user-friendliness of quotes is so critical, it is important for traders to ensure they have premier quote services. If a premier service costs $250 additional per month, simply consider this is a must-have expense, a $1500 per year expense without which you can not successfully operate your venture.
2. Internet Service Providers
Along the same lines as quote services, most traders capitalize on the wealth of information available on the internet. Many obtain their quote and research feeds via. the internet and have access to the incredible wealth of fundamental and technical research available online. It is important for traders to ensure they have the highest quality internet connections with ample bandwidth.
Most 33.6 connections are simply not sufficient. Too many traders are relying too heavily on 33.6 connections that are not well suited to professional work. Pursue multi-linking multiple 33.6 connections which can effectively provide the necessary bandwidth affordably. While ISDN can be costly, cable modems are offering traders a low-cost, high bandwidth alternative. Anticipate spending $50 to $150 per month for internet connectivity at a minimum.
3. Brokerage firms
The brokerage firm through which you execute your trades is a critical choice for all traders. I would generally eliminate full-service firms such as Merril Lynch and Goldman Sachs, as their market making departments are not suited to investors looking for the highest quality executions. As well, the higher commissions are not justified as traders are typically simply looking for quality of execution and not financial advice. While such firms offer premier services well suited for certain investors, it is not the province of the more active trader.
There are many discount choices available for traders. I classify acceptable brokerage firms into three types:
1) the inexpensive, internet based firms such as E-trade, Afhauser, Ameritrade, which either make markets or non-discriminatorily route orders to such market makers;
2) the direct order entry firms such as MB Trading and AB Watley that require you to understand and manipulate the idiosyncrasies of the multitude of execution system, in addition to timing and selection of securities, and
3) Trading oriented discount firms, such as Yamner & Co., Inc. (http://www.yamner.com) which offer direct and immediate access to their trading desk, a full range of execution systems, at discount commissions, yet your order is handled professionally by their skilled traders acting on your behalf.
The choice is a difficult one for most investors. While $5 commissions are attractive, it is the wrong focus for most traders. Simple math reveals that the real cost of any transaction is not the commission on the ticket, but rather the quality of the trade. If you enter a market order to buy 1000 shares with firm A and pay 10 ¼ and the same transaction at firm B could get you 10 1/8, the trade cost you $125 more at firm A than Firm B. No matter how you classify the cost, you have clearly paid more for your transaction at firm A.
While some will argue that any of the above firms might be suitable, and that 1/8s and ¼ may be less important for longer-term investors, I disagree. Regardless of the savings, I would always rather have it in my pocket than in someone else's. As well, you have no idea to what degree you may experience improvements through employing a higher quality service. For more active traders, these improvements and quality executions are critical to success.
Many investors do not understand the markets well enough to understand how execution quality can vary from firm to firm. Some are not familiar with the markets and how the stocks trade amongst market participants. If you do not understand these concepts yet, you should not be considering trading yet but rather spend more time learning all that you can about the markets.
One source I would recommend is Yamner University (http://www.yamner.com) While both commissions and quality of execution are important, the value of the execution should be your primary concern.
Additionally, most traders are well-advised to leave the executing of orders to a well-positioned trading firm, with the necessary execution systems, leaving them free to focus on the selection and timing of transactions. There are multiple components to succeeding as a trader including 1) picking the correct stock 2) timing your purchase, 3) executing the trade effectively and obtaining the best price and 4) maintaining sell-side discipline through the use of stops, limits, etc. A firm like Yamner & Co., Inc. employs more than 20 execution systems; many used in conjunction with one another to obtain the industry's highest quality executions. Our firm traders have many years of experience utilizing these systems and are best positioned to provide you with the execution services you desire. Letting a firm like Yamner & Co., Inc. focus on the executions and offering you stop services on listed and over-the-country trades allows traders to focus their efforts on picking and timing their selections.
4. Choosing The Markets to Trade
I often suggest that traders pick less volatile, less active stocks to trade. This is contrary to what most traders do, which is trade is trade the Dell, Amzn, Msft and INTC's of the world. While less volatile selections do not offer the glamour and fame of trading the world's wildest issues, they often offer better odds at success. The elite, well known trading companies such as Dell, AMZN, MSFT, etc., is manned by the best traders at the best market making firms. These firms are willing to commit millions of dollars in resources to ensuring that the best traders and best technology are governing the handling of these issues. As well, the best non-market making traders also focus in on these issues. Would you rather be the big fish in a smaller pond or the small fish in the big pond? I always choose environment where I have the advantage.
Trading less volatile stocks gives traders a chance to learn how market makers operate, how the business of making markets transpires. After all, traders are themselves making a market, buying lower than the price at which they wish to sell.
I also strongly suggest that traders analyze the opportunities on listed exchanges. Exchanges such as the NSYE and AMEX offer greater liquidity and depth. Bids are typically more substantial and liquid. As well, some of the best companies in the world trade on these exchanges. While misperceived as offering little in the way of electronic executions, the NYSE offers the Superdot system that often outpaces any NASD execution system.
5. Hedge Risk
The idea of hedging risk is a much-debated topic amongst traders. Yet virtually all successful trading firms and funds employ tremendous risk management processes. In general, I find the less successful participants to be somewhat carefree in their limiting of risk, in their approach to the markets, overly confident in their decisions and without regard for the true potential for horrific losses. As any seasoned trader will tell you, the market knows no mercy. In the same fashion that it can yield incredible results, it can be quite punishing. Every trader has taken serious thumps and the truly successful traders are those that learn from their mistakes.
For traders, their principal is their number one asset. Nothing is more important. Without it, they have no business. Think of your principal in the same regard as a world-class pianist might consider his or her fingers. While it seems overly simplistic, a trader's goal should be to maximize winners and minimize losers. Let your winners run and sell your losers. Water the flowers and pull your weeds. Don't do the reverse. Psychologically, many traders become lured to sticking with losers. In retrospect, most failing traders have a similar outlook, that they had some wonderful trades yet they can pin their losses on just a few ugly positions. Eliminate those losses from the account and the trader would have been far more successful.
Traders hedge risk in a number of ways, all of which require solid discipline, particularly sell-side discipline. Traders can not be successful striving for 5% gains while tolerating 20% losses. A trader can not survive 3/8 point gains and ¾ point losses. For that reason, most successful traders point to the use of stop loss orders to help limit their losses. Some traders utilize a percentage stop loss, that is they set a stop at x percent below the price they acquired the position. Some traders use a trailing stop that is a stop that is always one point below the price of the stock. As the position appreciates, they adjust the stop higher so as to let the stop take them out of the position. Be sure you are working with a firm that takes both stops and limits and combinations of stops and limits on both listed and OTC stocks.
Traders also hedge risk by not taking home any positions or overly concentrated positions. Many would disagree given the incredible volatility general found at the market openings, with gaps at the bell. After all, sometimes the easiest 1/4 point gains come from taking home stocks and seeing the S&PFutures up 4. Nonetheless, it is this exact volatility and general inability to measure change in sentiment overnight that demands that most traders go home at night, over the weekends or holiday periods, flat to the market.
Generally speaking, there are opportunities each and every day, throughout the session. It is only with hindsight that taking home a security would have been worthwhile. Without the ability to hedge risk overnight or over the weekend, it is suggested that traders eliminate positions before the trading session concludes.
Nonetheless, by definition, position traders must take home their positions on occasion. They do so with risk allocated and measured and a clear strategy as to how they will handle reversals in their positions.
I have seen traders employ momentum strategies and purchase stocks of mutual funds at or near the end of a trading session, gauging momentum and anticipating a gap open the subsequent morning. This is a predetermined allocation of assets to this strategy. This does not mean that the trader found himself in a losing trader and unwilling to liquidate the position with a loss, takes it home. A trader making such an election may also exercises the same level of discipline in selling the position at the open the following day.
The use of options, allocation and diversification also gives traders necessary hedges against positions. Position traders often will write calls against the positions to capitalize on short term volatility in options and to generate additional income. Regardless of the investment strategy employed, traders should pursue means of hedging and reducing risk. Minimizing loss of capital is critical to ensuring success as a trader.
6. Be critical of yourself.
Unlike hobbies and recreational activities, which can be pursued regardless of talent, trading securities is a profession. Often, individuals must come to the realization that they simply do not have the temperament, skills or intuition to trade securities as a profession. It would be unreasonable for individuals to pursue a career in basketball to the exclusion of other opportunities when their efforts are met simply with failure. To the same degree, traders must not become complacent. Expect the worst and outperform your expectations. But be prepared to realize that you might not have what it takes to make a career of trading securities.
Set limits as to how much capital you will commit to determining your potential for success. If you fail, call it quits. Do not act like a gambler at the casino, searching for the ATM cash machine. Set reasonable limits, and stay within them. If you do not have the discipline to maintain these limits, you most likely do not have the discipline to become a successful trader.
Traders need to approach their venture as any entrepreneur would view any new business. Discipline and prudent business practices should be employed. With the necessary tools, a desire to succeed and the discipline required for the professional, traders can greatly increase their likelihood for success.
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