Day Trading and Technical Analysis: Is History Destined To Repeat?

Technical analysis is the complete opposite of fundamental analysis so it's no wonder that Day Trading is one of my least favorites strategy. This is a high-risk strategy, even for those that master it. The vast majority of new day traders don't last a year, they lose enough money to be scared into a different strategy, sometimes entirely out of investing. Day Trading requires an enormous tolerance for risk and uncanny intuition that only comes from years of study and experience.

Technical analysts select investments by analyzing chart patterns, historical price action, statistics and options "greeks". They believe that their time is best spent trying to anticipate price movements in stocks, indexes, options and other securities. The goal of technical analysis is to recognize historical trends in chart and price patterns and profit by anticipating how the next piece of the pattern will play out.

Day Trading is almost exclusively a short-term trading strategy, very few positions will ever be held beyond the close of the current trading session. This is the major reason day traders depend on technical and statistical analysis, because other forms of analysis such as fundamental analysis are long-term oriented. Many technical analysts feel that other forms of analysis are not useful because factors such as political events, market psychology, economic factors, and fundamental factors are almost instantly reflected in a security's price.

The most common type of investment for a Day Trader is options. Options are a form of derivative, and this means that the value of an option is based on an underlying security such as a stock. More specifically, an option's value is based on the behavior of an underlying security.

While this strategy isn't the most research intensive, it is definitely the most time consuming. The term "Day Trading" can be taken literally. You will be required to check the market frequently since you can lose a great deal of money very quickly if a trend reverses against you. Most professional day traders check the market, their open positions, and any chart patterns that they're tracking many times per day.

So what is our biggest complaint about options trading? We don't really have anything against the strategy. In fact, there are a couple trades, such as covered calls and selling out of the money premium spreads, that we feel offer acceptable risk vs return and can act as great hedges against risk. Our problem is that there are so many "we'll make you rich" options experts out there. Too many new options traders get suckered into these expensive programs and lose a lot of money. Not only are they getting terrible investing advice, they are trading securities that they don't understand. Successful options investors will tell you that it takes years of experience to get a feel for options trading, but there are a lot of scammers out there selling "secrets" or trading tools that will supposedly enable novices trading like pros immediately.

Investment Selection Methods

Day Traders use technical analysis to identify investments and evaluate their open option trades. Technical analysis is a combination of charting, statistics and Greeks used to predict price movements.

Day Traders use charts to try to identify and predict price patterns. There are far too many chart patterns to discuss or even list, but below is an example of one of the most popular, the cup with handle.

Cup with Handle Example
This cup with handle example is a bullish pattern designed to help technical analysts identify stocks that have experienced a consolidation period that is predictive of a price breakout.

There is also a lot of terminology specifically associated with options. A few examples you may have heard are are In the Money, Out of the Money, and Expiration. In the Money means the price of the underlying asset (usually a stock) and the strike price of the option are such that the contract could be exerised for a profit. Out of the money means the option is currently worthless because the strike price is outside the price of the underlying. Expiration refers to the fact that options expire after the date specified in the options contract.

Statistics are particularly important to day traders when we talk about risk. Technical analysts use statistics to help guage volatility and measure the odds that events will or will not occur. Two common statistical measures that technical analyst find useful are standard deviation and beta.

  • Standard deviation: Standard Deviation measures how much an investment deviates from its average. For example, if $5 is one standard deviation for a stock that averages $40 and it is currently trading at $55 this tells a Momentum Investor two important things. One, the stock is very volatile and two, it has a lot of positive momentum since it is currently trading three standard deviations above its average.
  • Beta: Beta is useful because it measures an investment's volatility against a benchmark. For example, if you are comparing Bonds to Small Caps and the Bond beta is 0.8 this tells us that Bonds will grow less than Small Caps, 20% less to be exact. If the Small Cap index goes up by 20%, this means the Bond index with a beta of 0.8 will only increase by 16%.

To anyone that has never traded options, the geeks can be intimidating because words such as Delta, Gamma, Vega and Theta bring back painful memories of undergrad calculus. However, for an options trader, greeks are simply several statistical measures that are used to measure the sensitivity of an option's price vs changes in the underlying asset, volatility, and time to expiration.

Risks

The major reason day trading is considered the most aggressive strategy is that, due to the nature of options, you can lose so much money so quickly. This is true regardless of whether you are buying or selling options. For example, if you sell a naked SPX index put for $500 in premium, but the trend reverses against you sharply, you could lose tens of thousands of dollars on this one trade. With naked puts, the loss potential is unlimited. When you're buying options rather than selling them, your losses are limited to the amount that you spend on the contract, but the odds are usually much higher that you will lose money.

No one has ever proven that they can consistently predict the market or individual securities. Even the best options traders will tell you that they are happy if they are betting right 60-65% of the time. When you are only getting it right a little over half the time, you will have to have a great risk management plan in place to limit losses. You'll also have to have an incredible feel for the market and for the stocks and indexes you trade to profit much more on your good trades than you lose on your bad trades. This brings investor psychology into the mix, and that usually spells disaster for beginners. Greed and fear are tough for beginning investors to deal with, they will often take a profit too early or hold onto a losing option too long because they are hoping it will go back up.

Benefits

Some traders do master this strategy, but very few successful day traders are your average individual investor. Most are professional traders that spend every trading hour studying the stocks and indexes that they trade and managing their open positions. Many people that trade options successfully are professional hedge fudn managers and mutual fund managers that use certain types of option trades to hedge their portfolio's risk rather attempting to make a profit.

One redeeming quality of technical analysis is that people are finding many mainstream applications. Technical analysis, particularly the charting and statistic components, can be great for determining entry and exit points and identifying unusual movement in your securities or the market.

Long-Term Outlook

This strategy will always be around because there are so many investors looking for easy money. That's probably why there are so many scammers selling option trading "secrets" that promise to help beginners instantly trade like professionals. Too many new investors today seem to be looking for quick wealth. Unfortunately, it's going to take years of hard work to master your strategy, regardless of which one you choose. The good news is that everyone can build wealth as long as they have the desire and discipline and work hard to master a proven investing strategy and good savings and spending habits.

Investor Profile

This is a high-risk strategy, many new investors choose this strategy because of the promise of huge returns but those promises are seldom fulfilled. The odds are not in your favor, even the best day traders are only getting it right about 60%-65% of the time. Even if you can match this %, the odds still aren't in your favor because you have to make a lot more on your good trades than you lose on your bad trades, a daunting challenge when you factor in investor psychology. This is a strategy for those with nerves of steel, an uncanny intuition for market and stock trends, and 40+ hours a week to study strategy and watch trades.

If you are determined to master this strategy, I recommend that you start simple and relatively safe with high-probability spreads and covered calls. Even then it will still require a high risk tolerance and willingness to take big losses now and then, but this approach gives a much better chance of surviving the first year and making some profitable trades.

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