Experienced active traders know a lot about getting out of stocks quickly. The good ones have stop limits set, at least mentally, to exit a position when their stock has dropped to a specified level. They have learned to always be thinking about the downside risk of their positions. They do this kind of defensive thinking much better than intermediate- and longer-term investors, who think they don’t really need to bother with it.

But what about day traders holding positions longer, rather than the knee-jerk reaction to sell when it goes down an eighth or a quarter? In other words, have active traders gone overboard when it comes to quickly exiting positions? This question, of course, goes to the heart of the whole method of grinding out fractional gains.

It all depends. If there is a lot of money on the line and say, 500 or 1000 shares, obviously to preserve capital, active traders are forced to exit positions quickly when their stock drops a fractional amount. They can’t risk losing a chunk of their capital. If they have 1000 shares and the stock goes down a quarter point, they are down $250 plus commission costs. This, as every trader knows all too well, can happen very fast. It is the best argument for not trading in larger share lots until you become very experienced. But let’s say they’re only trading in lots of 100 or 200 shares. Then if the stock drops a quarter point and it only is worth $25, they will not feel so desperate to get out of their position. They can watch the stock a while, and give it a chance to come back to at least where they bought it.

I understand that it is tough to make much money when that quarter point doesn’t mean more than $25. But if the object of the game is to preserve capital and carve out fractional gains, what’s the matter with carving out a few hundred dollars per day with far less risk?

I will never end up a scalper because it simply is not compatible with my personality. And there is no compelling reason that I can see to try and fight my personality and natural trading approach. I have concluded the risk-reward ratio is not favorable for me to deal with the stress of scalping. Swing trading makes somewhat more sense to me but is still quite nerve-wracking, and position trading makes more sense still. But my own preference is for what most would label the intermediate term¡ªa few weeks to a few months. Some call this “speculative” trading, viewing anything short of holding for the long-term as too risky. But speculation that is informed is clearly in a different category than wild gambling.

For example, if CMGI has one of its “incubator” Internet companies coming to market with an initial public offering, I know that the parent stock will rise when the new company becomes public. This is not really any risk-¡ªit will go up when one of its companies comes out. Buying CMGI for the short term then is informed speculation and what the position trader specializes in. But to do this kind of position trading, you can’t be phobic about holding a stock for days at a time.

I recently talked with a professional who had been involved in day trading for the last three years. She doesn’t do much day trading now, preferring to be involved in helping educate new traders. But she still trades selected IPOs as soon as they hit the open market. While this tactic can be quite risky compared to getting in on the initial offering price and being assured a gain almost totally risk-free, for her it seemed less risky than what she had been previously doing as a day trader. She told me that when she learned day trading, she was a victim of being taught that she “must” trade in 1000-share lots to make any money. She said instead of making money, this approach cost her a lot of money¡ªboth in working capital and in commissions.

She told me that if she were to do it again, one thing she would do differently, in addition to trading fewer shares, is stay in her positions longer, not being in such a hurry to get out as soon as the stock dropped a fraction. This is counter to what most traders think. They tend to err on the side of not getting out fast enough, even though they are far better at exiting than longer-term investors. But this trader’s opinion was that often her stock would come back the eighth or quarter within a couple of minutes. And if she hadn’t had 1000 shares riding, she could have taken this chance and held on to it longer.

The Dating Game: “Can I Bring Her Home to Meet Mother?”
I talked with another professional trader who has been buying securities for many years and trading the last two years through direct access at a trading firm, and was now teaching an advanced class for day traders.

The analogy he used for day traders extending their positions beyond scalping for fractions was one of getting to know a new woman gradually. He said he needed to begin slowly by trading the stock for fractions, getting to know it day after day, but not holding it for very long. He likened this to having casual greetings and maybe chit-chat with an attractive woman where there was some interest but not really spending much time with her.

As he felt more comfortable, he held the stock for hours at a time, doing swing trading. This was the equivalent of showing interest and going on dates with a woman to really get to know her. If this dating worked out and he didn’t lose any money holding his position for hours, sooner or later he would take the next step in the “relationship” and take the stock home with him overnight. This was the same for him as a couple deciding to finally spend the night together.

If he didn’t end up with a losing position by holding her overnight (still liked her the next morning), he began to think maybe it wasn’t just a fling. Maybe he could develop a longer-term arrangement with his new sweetheart stock. He would then consider holding the stock for weeks or months, in a steady (but not necessarily exclusive) dating relationship. If all went well, he might eventually marry the stock (as he had Microsoft) and never sell her no matter how badly she treated him; he took her for good or bad, ’til death do they part.

This trader/investor had developed a method of making the stock prove itself worthy of becoming a long-term hold. But the point here is he made room in his thinking and behavior to become not just a day trader but an investor as well. He borrowed something useful from investor’s-mind to add to his armamentarium as a trader. While most men and women don’t put the stocks that end up in their portfolio through the same kind of rigorous courting ritual as they do their potential love partners, it isn’t a bad model or analogy for the day trader to consider.

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