“I am a genius!” I was salivating over all the money I was about to make. This was the first trading idea I had put together on my own. Didn’t see it in a book. Didn’t see it in a magazine. Nope. This one was mine!
You are now reading the first in a series of posts I’m going to make about important learning experiences I had while developing as a trader. I spent a lot of money on these lessons… I hope you don’t have to!
The Idea
I had just opened my large trading account, and was getting my feet wet in the daytrading arena by trading two days a week (I arranged the time off with my employer, and still gave them over 60 hours a week, regardless). I knew traders were supposed to trade high-volume stocks, for their liquidity, so I was studying their charts. A certain class of stocks in this group caught my eye.
Think of stocks like Sun Microsystems (Nasdaq: SUNW), Sirius Satellite Radio Inc. (Nasdaq: SIRI), and Lucent Technologies Inc (NYSE: LU). These are all very low priced, very high volume stocks. As a result of their low price (with correspondingly small trading range) and the relatively huge number of shares changing hands, you tend to see this a lot:
That’s a pattern from today on SIRI, covering over one and a half hours of trading time. Some days, the pattern held for much longer. The bid and ask were practically static, one cent apart, and the prints were bouncing back and forth between them. Can you guess my brilliant plan?
- Wait for the pattern to develop
- Buy 10 or 20 thousand shares at the bid via limit order
- Immediately sell the shares at the ask via limit order (gain $100 to $200)
- Repeat until rich beyond wildest dreams
That’s it. Simple. And, if you look at the picture, you can see that I thought that a drop in the bid would mean selling at the ask to break even.
How Did It Go?
There were a couple things I didn’t count on in terms of execution. If you look at the Level II quotes on these stocks, you’ll see how large the size on the bid and ask are. This means that a limit order to buy tens of thousands of shares at the bid and sell at the ask can take quite a while to go through. Also, I wasn’t considering the time it takes to modify and cancel orders when the stock starts moving against you. It can mean the difference between a 1 cent loss and a 5 cent loss!
Still, the first two or three trades I made worked just as intended. I was thrilled. And then, the next one didn’t. Worse, my beautiful plan to get out at break even did not pan out. You see, because the bid and ask are so deep, it’s easy for the bid and ask to keep dropping before you get filled, even though lots of shares are trading hands at each level. So, you give up on limit orders and issue a market order, during which the bid can drop even further.
Put all this together, and it appeared that I would have to win at least 4 times as often as I lost, and even if I pulled that off it’s just not that profitable (you end up trading 100,000 shares to make $200 net profit!).
I kept trading, and kept getting similar results. Up $300, down $400. Up $400, down $300. Then, I had it move five cents against me, and like many beginning traders, I became irrationally confident that the stock would go back up. I’d be sorry, I reasoned, if I got out now for a $500 loss. But, it kept falling, and I closed out a couple agonizing hours later, down $1500 for the day.
What Did I Learn?
Let’s ignore that last part, about not being able to take a loss. This was just one of many examples of that particular problem from early in my trading. It was certainly a costly mistake, but tangential to shortcomings I want to expose in this story.
In formulating and executing this idea, I made several beginner mistakes:
- I only looked at the areas of the charts where this system would work. It’s a human trait to find a couple cases that work, and overgeneralize from them. It’s also a human trait to assume a repeating pattern will continue to repeat.
- I had capped my upside by immediately selling. If the stock tried to run up, I would still get filled at 1 cent of profit. However, it’s hard to truly cap the downside to 1 cent because of the issues described above. So, I had locked in a reward smaller than my risk.
- I gave no thought to the overall trend of the stock, or the health of the market. In other words, I was making trades with no context.
From these mistakes, I learned (or at least started to learn) the following:
- You have to control your enthusiasm. Make a conscious effort to look for the cases that don’t work, and see how bad they are. If you don’t set out to find the failure cases, your brain will have a tendency to gloss right over them. Be aware of the ways human cognition can fool you. The brain is wonderful at spotting patterns in data, even if it has to fill in data that’s not actually there!
- Even if you don’t perform a full historical backtest, always at least try to estimate the expectancy of your plan. That is, given your expected gains and losses, what kind of win rate will you need to make the plan pay off? Can you achieve that rate? Always factor commissions and slippage into your plan. For some reason, I have always been good about accounting for commissions, but I used to always assume my fills would be immediate and pristine. Now I allow for some error.
- Trades should not be taken in isolation. A stock’s trend (or lack of one) today is happening in relation to longer term trends (or lack of them) in the same stock. Also, stock motion is happening in relation to the overall market. It was after this failed experiment that I spent time learning about TICKs and TRINs. Since then, I’ve found really no use for the TRIN–I can’t derive anything useful from it. The TICKs for both NYSE and Nasdaq, on the other hand, are always on my screens now.
- It’s dangerous to trade on a scale that is essentially just price noise. Trying to catch 1 cent up, and get out at breakeven if the bid drops 1 cent, is relying on a certain amount of order inside that noise. That order doesn’t exist, by definition. Your brain just makes you think it does, when you look at time and sales data that’s already past.
Could this scheme be improved enough to be viable? I think not. If you disagree, I’d love to hear your ideas.
| Stocks Mentioned In This Article | |
|---|---|
| Stock | Links |
| SUNW |  |  |  |
| SIRI | | | |
| LU | | | |
July 24th, 2006 at 5:46 am
[...] Like most people, we are interested in making money work for us. So we thought, “What about large caps?” The problem is, there is no free lunch. We can’t help wonder what is the best day to trade stocks? And worst of all, we are worried about rogue waves and the stock market. If our plan became siriusly flawed it would be a FrightFest. Then there’s commodities. We are hearing some interesting stuff about peak oil. But what if water turns out to be more precious than oil? If only we knew the basics of precious and base metals investing we might have an idea where to start. As it is, the choices make us dizzy. [...]
July 30th, 2006 at 3:36 pm
[...] This is the second installment of the Evolution of a Trader series of articles. It’s a series about important learning experiences I had while developing as a trader. I spent a lot of money on these lessons… I hope you don’t have to! If you are new to the series, you might want to check out the introduction article, and the first installment. [...]