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TRADER'S NOTEBOOK


Trading In The 21st Century

06/04/02 03:59:29 PM PST
by Tom Busby

Equipment, education, and method -- three necessities for successful trading.

It wasn't so long ago that it was very important to buy stocks with dividends and only sell on an annual basis. Then in the early 1980s, the Standard & Poor's contracts started trading in the Chicago futures pit, and things haven't been the same since. Introduced in the form of S&P futures was a vehicle that allowed traders to enter and exit the market multiple times per year to increase net worth. The ensuing shift in philosophy set the stage for a changing market and led to the economic boom of the 1990s.

Initially, the most important tool a trader had was a connection or relationship with a pit trader. In the mid-1980s, the advantage of execution clearly went to the pit; the back-office trader was confronted with higher transaction costs and less leverage — a real disadvantage. Not only that, only the large brokerage firms had access to the pit, which was a drawback for the small investor. In addition, brokerage costs were high and the electronic age had not yet begun to aid in order execution. The history of the Dow Jones Industrial Average (DJIA), the benchmark of the market (displayed in Figure 1), shows a nice picture of this:

Figure 1: Dow Jones Industrial Average (1897­2000). In the 1990s there was more market participation.

The markets took off after the oil glut of 1982; the electronic age was new and discovering fresh territory every day. Personal computers had just been introduced to a wide audience, and order execution became easier. The brokerage houses started sending large orders to the floor electronically instead of verbally, decreasing the execution time and manpower needed to trade the markets. By the late 1980s, electronic execution was well on its way to being the main stream for order flow.

In late 1987, however, electronic order execution got its first look at chaos when the markets plunged in October. Selling set in and as the markets declined, electronic order execution soared. The order flow was so heavy the trading floors could not keep up. Buyers and sellers were left to wonder where their fills were, or if they got filled at all.

ELECTRONIC TRADING

The next several years after the crash of 1987 saw new regulations and restrictions on electronic order execution. Limits were set on a percentage basis of decline during the trading day; this decreased the order flow to the trading floor so market makers could maintain a fair and orderly market. The 1990s, however, brought about a new style of trading and investing when electronic order entry and execution were introduced to the small investor.

This Internet-based technology started shifting the odds; the computer-oriented trader started gaining ground. These new investors were computer-savvy and knew how to maneuver through the markets at breakneck speed. Their Achilles heel, however, was overconfidence and a lack of market sense. They knew how to trade electronically, but they didn't understand how the markets worked. In the basics, the markets hadn't changed; all that had changed was the way orders were executed and data was transferred. The computer trader flew high for a while, buying every Internet initial public offering (IPO) and selling it for 300% profit. But this came to an end all too soon.

The early part of 2000 hurt the new era of computer traders when the soaring Internet stocks started to plummet. Unfortunately, most just saw the plunge as a correction in a bull market; as a result, many investors held onto the high-flying stocks and even added to their positions, only to discover there would be no rebound. The advantage swung to those traders who were familiar with computers, had market knowledge, and could execute for profit in an up or down market — the three necessities to trade in today's market.

TODAY'S TECHNOLOGY

The high-flying Nasdaq was eventually brought back down to parity with the overall market, but a contributing factor to its flight (and fall) was the technological advances of today. The Internet is powerful, there is no doubt about that, but inevitably, it can fail. If you are completely reliant on a computer for your trading, then when your computer is not working or your connection to the Internet is down, you will be cut off from the market. It is important to understand that a computer is nothing more than an advanced tool.

Besides having a computer adequate for the job, the first essential software for the computer-oriented trader is a dependable datafeed. An Internet-based datafeed keeps you most versatile; with a laptop and a dial-up modem, you can plug into the markets from anyplace there is a phone, and some mobile phones can provide the same level of access. Electronic trading platforms are usually available through your broker or clearing firm.

However, a number of variables are involved in electronic trading. There will be times when your electronic trading platform is not accessible. Having a cellphone handy with your broker's phone number is a good idea. Do not wait to find out if the problem might fix itself. Most electronic trading platforms have you sign a release protecting them from liability should you discover your trade did not go through as desired. You and only you are responsible. Keep accurate paper records and rely more on the statements from your clearing firm than those of your electronic broker.

MARKET SAVVY

The stock market reflects the economic pulse of the world. Most traders and investors are inundated with too much information and have no way of profiting from the input. Understanding and reacting to this information will determine your profit or loss.

A good example of this is the bond market. The bond market is priced on the current direction of interest rates and inflation; higher rates bring about lower bond prices, and lower rates bring about higher prices. As the maturity of a bond is extended, the rate of inflation becomes a factor in the bond prices. As rates rise and equity prices drop, the flow of capital to bonds increases. The opposite occurs when rates rise, and equities are the recipient of the decreased capital flow.

TRADING METHODS

As a method trader, I start with a simple analysis of whether to be long, short, or out of the market. Unless you get this all-important question right, your results will suffer regardless of your approach. Being on the right side of the market always pays, but to make sure you're there, you need to develop the proper method. Some of my tools include determining key numbers (support and resistance) and time of day (when volume and liquidity are present), as well as use of a "roadmap" (evaluation of technical indicators to determine reaction).

The key numbers are support (which holds the market up) and resistance (which keeps the market from going higher). There are many techniques for determining these key numbers; one of the best sources is the market itself. As the market trades higher or lower, it will stop at certain points and retrace. The points at which the market stops are support or resistance. Making note of these key numbers will aid you in determining where to enter and exit the market.

Time of day is another important factor to consider when looking to enter the market. For the market to move, it requires volume and liquidity. There is more volume and liquidity at certain times of the day than others. When volume and liquidity are low, the market has no real trend and is therefore much more difficult to trade. When the market has no momentum, a trader will find it difficult to determine its direction. Trading while volume and liquidity are high, however, will place the odds in favor of the trader.

The final tool is a trader's roadmap, which represents how the trader will negotiate through the jungle of the market, using indicators to help determine direction. These indicators will tell you if there is increased buying or selling in the market. I have developed software that tracks these indicators so I can make a quick decision and maximize profit.

A successful trader should be adept at interpreting, analyzing, and executing trades. The market changes its language day to day, and translating it is one of the most difficult tasks you will encounter. The use of certain tools will aid in breaking this code to increase the odds of being on the right side of a given trade. The use of key numbers, time of day, and a roadmap will facilitate your success. Without these tools to determine the correct trend, you will not last long in the market arena.

Thomas L. Busby, founder of the DayTrading Institute, has been a trader, broker, and registered financial advisor for more than 23 years. He opened the institute in 1996 to educate, train, and support individuals who want to manage and trade their own accounts. For more information, please visit www.dtitrader.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Tom Busby




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