B
y now you should be thinking about what your trading shtick will be.This is a good time to explore in a little more depth the ways you can enhance your success—and also note some areas you might want to avoid, at least in the beginning of your career.
Initial public offerings (IPOs) come to mind as an attractive, yet dan- gerous, trading opportunity. These are stockofferings made to the public for the first time. For example, a privately owned company may be in business for a period of time. It could be months, years, or even decades.
The owner(s) decides to take it public. This is done for a variety of reasons. The owner might want to get his or her money out of the com- pany before retirement. Or that person might want to divide the company among family members or employees, which is easier to do if stockcer- tificates can be distributed. Some companies go public as a last-ditch effort to raise money before bankruptcy. The most exciting IPOs are usu- ally the ones where the company has a big idea or opportunity that man- agement wants to take advantage of and needs some serious financing to do it. A common recent variation of the above is the dot-com begun on a shoestring, grown with venture capital, and now primed for a big-time payout to the owners, investors, and employees.
Companies traditionally go public through brokerage firms that un- derwrite the initial stockoffering. Underwriting the cost means fulfilling
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all the legal requirements, which can be staggering and expensive, plus organizing, funding, and promoting the sale of the new stockissue to the public. In return, the broker-dealer is reimbursed out of the proceeds for its expenses, and it controls who gets access to the new shares before the public does. This is done using an offering memorandum reviewed by the Securities and Exchange Commission containing all the information an investor should know before investing. The lead broker-dealer may form a selling syndicate. You, as an investor or a trader, may be able to obtain access to shares of the stockin one of two ways. First, if you are a big customer of the underwriting firm or a brokerage firm that is part of the selling group, you may be offered an allotment of shares at a set price, the offering price, before the IPO is launched publicly. Some of the initial shares of some public offerings were also offered through major online brokerage firms when IPOs were very hot items a few years ago, but this is not the traditional venue. If you don’t get an allotment, you can buy shares the day the IPO begins trading on an exchange. Trading publicly on an exchange is called the secondary market.
This whole process gets exciting when the stockbecomes a “hot is- sue” the day it begins trading. A hot issue is one in which price takes off like a bear being chased by swarm of bumblebees. During the famous dot-com years, the action was nothing less than astounding. VA Linux Systems set a 1-day record by opening at $30 per share and closing the day at $250, while hitting an interday high of $320! The record holder for the year (1998) was Red Hat Software, skyrocketing 1837 percent by year’s end. IPOs that merely doubled or tripled on their Nasdaq debut were commonplace during these times of irrational exuberance. If I re- member correctly, neither of these hot issues ever made a penny, at least for the first few years. During that period, earnings meant nothing—
growth was everything. For an investor this is not necessarily the best environment, but for a trader it was a dream come true. This is part of what is meant by understanding and becoming attuned to the complexion of the market. There are times to day-trade. There are times to make swing trades lasting several days. There are times to hang on to positions for weeks and even longer. And there are times to buy and hold. Expe- rience will teach you the difference.
Does it make sense for you to trade IPOs on the secondary market?
My answer is no. It is gambling, not trading. My reasoning goes like this.
Traders should always be looking for an edge, not giving one away. An IPO on day one has no technical history—no charts, no moving averages, no price history whatsoever. Therefore, there is no trend to follow, no
setup chart formations to lookfor, and no way of anticipating which way the stockis headed once it comes out the chute. You don’t know how to read volume because there is no baseline.
There are two kinds of IPOs—the hot and the not. When IPOs are hot, a feeding frenzy occurs among amateur traders, as we saw during the dot-com heyday. The energy and excitement are overwhelming. They can’t be contained and they are not rational. Manias in financial markets are common and have occurred for as long as there have been markets.
We all have read about the South Sea island and tulip bubbles. The In- ternet and dot-com craze was no different. When these bubbles occur, everyone and his brother launch IPOs. Traders can’t wait to get in on the action. There isn’t enough time or solid information to judge the jewels from the junk.
Then comes an even tougher question, how do you trade or day-trade a bubble? Weeks before the launch date, the Internet is abuzz with wild rumors about how hot the next IPO will be. Amateurs hound their broker to get them in on the allocation, which is usually severely restricted. They then give the broker market orders to get them in on the open. The day a hot IPO finally goes public, there are a ton of orders backlogged. The price gaps higher two or three times at the open, and the market orders get filled at prices two or many times higher than the offering price, which is the price you would have gotten it at if you had been allocated some shares. The stockprice continues to explode to the upside, and greed rules the trading floor. Everyone wants in; no one seems to want out. But someone must be selling into the storm in order to get the buy orders filled. And those someones keep jacking the price higher.
Then out of nowhere prices deflate like a punctured balloon. The stockcloses lower than the opening price. What happened? How could this be? There are a couple of things happening behind the scenes. First, stockbrokers of the underwriting firm got their best customers a portion of the stockallocation. These lucky investors were in before the open.
Their brokers then sell them out as the great unwashed rush into the market. A worse situation, in my opinion, also occurs when the under- writer or members of the sell group allocate stockto hedge fund managers or large traders. They flip the stockas soon as they can for a healthy profit. In return, the hedge fund runs other trades through the broker- dealer at an unusually high commission rate as payback. To my way of thinking, the game is rigged in favor of the house when it comes to the hot, or the most attractive, IPOs.
The other kind of IPO, the not hot one, is strictly luck of the draw.
Without any trading history to go on, you lay your money down and hope for the best. At times, it goes well, and the price moves up 5 or 10 percent.
But how much is high or too high? Without areas of resistance to alert you to what previously cooled enthusiasm for the stock, how do you know when to get out? More importantly, if the price moves against you, when do you bail out? Zero is the only support level on the chart on that day.
This is gambling if I ever saw it, and gamblers, or traders acting like gamblers, are not going to retire rich and famous or make it into the next edition of Market Wizards. The gambling mentality has a basic flaw. It makes the assumption that past trades will have some impact on future ones. Gamblers are known to double up after losing a string of bets.
Theoretically, if you double up your bet each time you lose and do it until you win, you will be ahead. I suppose this may be true if you have enough money and time to stay in the game—and if the game stays open until you finally score. Besides the stress of getting farther and farther behind the eight ball, there are too many “ifs” in this approach for me.
Trades per se do not have any memory, nor do they feel any obligations to the trader. Each trade is unique unto itself. It stands solely on its own merits. There is no law of physics dictating that if you make five losing trades in a row, the sixth will be a winner. The opposite is equally true.
If you make five winning trades, the next might or might not be a loser.
Thinkbackto your high school math class when you studied the probability of flipping a coin. No matter how many times you flipped it, there was only a 50-50 chance of a head or a tail. If you flipped 10 heads in a row, you were not guaranteed a tail on the next flip. Trades are the same. Each one is unique. If you are in a losing streak, don’t start thinking the market owes you a winner. It does not owe you diddly-squat. After 10 straight losing trades, you must put the same workand thought into the next trade. You won’t get any freebies from the pits or the floors.
Good traders do play the odds, but in a different manner. The odds you should be studying are the odds of each trade being a winner given its own set of circumstances. Along with this you should have a plan of action if the trade goes sour. Survival—means getting out of losers as fast as you can. Trades are not bets. With a bet, you normally cannot cut your losses short. If you take the Lakers over the Celtics, you cannot cancel the bet at halftime if the Celtics are up by 10. You are in it to the end—win, lose, or draw.
This is an area that options traders must learn to manage more effi- ciently. It saddens me to thinkof all the clients of mine that bought calls
over the years and just let them expire worthless. No matter what I said or did, these people played options like gamblers would—buy, hold, and wait for the outcome of the game. Many did not even care about getting updates until just before the options expired. For some reason, they were convinced that their options would be most valuable at that time. Anyone who follows the markets knows the fallacy of this thinking. Calls made to these customers during the life of the option telling them that the underlying entity was up and they could get out at a small profit or break even fell on deaf ears. Hope of a big winner at expiration was the ex- pectation. If you have that mentality and are not willing to change, burn this booknow and stuff all your money underneath your mattress. You will be better off that way when you retire.
Just buying options, particularly ones with months to expiration, is a sucker’s bet in my opinion, unless they are being used to hedge risk.
Granted, a trader who is totally convinced the market is headed one way or the other may buy a call or a put to take advantage of his or her analysis. It is considered a conservative approach because that person can absolutely define the downside risk, meaning the premium paid for the option. It also provides excellent leverage. Nevertheless, I question the soundness of the strategy. My experience has convinced me that buyers of these types of options do not have good enough intelligence about where the market is headed to profit from the strategy. There are some good stories about winners, even a Chicago legend about a Woolworth’s clerkwho became a millionaire after he bought several calls as the Hunts attempted to corner the silver market in 1979–1980. I have even seen a handful of winners, but I have seen a bushel basket full of losers. It is my opinion that the size of the price move needed in the underlying entity to pay backthe premium and commission, and then drive the option far enough into the money to make the risk-reward ratio attractive, is not sufficient 99 percent of the time.
Thinkfor a moment about the risk-reward potential of the buyer com- pared with the seller of a call on IBM or COMEX silver. The buyer has unlimited upside potential and fixed downside risk, the premium. The seller has fixed upside potential, the premium, and substantial downside risk, from the strike price to infinity. Now it is very rare that any under- lying entity increases infinitely in value. Nevertheless, the buyer sure seems to have the better deal.
If this is so, why do most options expire worthless? Why would a seller of options be willing to take a theoretically infinite risk to pocket
a limited gain? What is wrong with this picture? I have sold more options than I care to admit, and my experience has been that the seller has a much better chance of success than the buyer.
I sincerely believe the reason is the work, attention, and thought the seller puts into the strategy compared with most, make that just about all, buyers, save hedgers. A seller of options, with so much more at risk, must determine how to price the option so the reward matches the risk. Then he or she follows the price activity and is ready to buy backthe options (to offset the position) or acquire the underlying entity (to cover the po- sition) if the sale becomes a mistake. The buyer, in all too many cases, sits passively waiting for the option to leap deep into the money. The buyer may even leave it up to his or her broker to signal when it is time to sell or the expiration date approaches. A good broker will do this, but no one pays better attention to your money than you do.
The seller is a trader of options—constantly on top of the market, buying and selling as market conditions warrant. The buyer is a gambler, betting on the future without trying to get an edge. The seller is trying to make a living, while the buyer is often betting on a tip from a broker.
The seller has the edge and will prevail in the profit-and-loss tug-of-war.
While we are discussing things not to do or to guard against, let me mention another. This one has to do with how our memories work. I call it the gambling casino syndrome. I really admire, yet avoid at all costs, gaming casinos. The reason is the same one that makes me admire good traders. Casino managers have mastered the art of putting the edge in their favor. I mentioned earlier the fact that the roulette wheel has a zero and a double zero, which gives the house an ever so slight edge. With proper volume, a slight edge is all that is needed.
But there is another edge that the house or a public trading floor has, and it’s at the basis of the casino syndrome. It has to do with human nature. All of us enjoy pleasure and shun pain. It is enjoyable to be around excitement and winners. Casinos have learned that people put more money into slot machines when there are a lot of slot machines in one place, rather than a lone one out in the lobby. Why? It is the constant noise of players and the excitement of someone winning, even if the lucky person hit a $100 jackpot after dropping $1000.
Keep in mind, the odds are the same—remember the coin-flipping exercise. For each dollar dropped, the slot machine is preprogrammed to win or lose at a given rate set by the house in its favor. You would have the same chance of winning if you were in the middle of the Sahara Desert at the Camel Stop Oasis by yourself as you would at the Bellagio. The
difference is that you might not continue tossing tokens in the slots if it was dead quiet—if there was no noise of winners hitting jackpots and none of the other excitement that takes place in a well-run casino.
The same phenomenon occurs on a public trading floor in the middle of New York, Houston, Los Angeles, or Denver. As a matter of fact, there is even a physical resemblance. In place of rows of slot machines, there are computers. Traders replace gamblers; at least they should be traders. Unfortunately, you may well find quite a few gamblers on trading floors. When you do, avoid them.
There is certainly excitement and winners, which is what I wish to warn you about. Trading floors are a mixed blessing. They can be an important part of your maturation from novice, to journeyman, to master trader, or they can be your downfall. One of the most serious pitfalls for the newbie is a tendency to overtrade when on a floor with a number of experienced traders. One of the worst things you can do is take a seat next to someone who has been momentum-trading for the last 5 years and is knocking off 50 or 100 or more trades a day. If this is your first experience or even if you do have some experience, it will plum drive you bananas. You will find yourself constantly peeking at that person’s screens, trying to find out what he or she is seeing, trading, and doing.
Like most of us, you will assume that activity is progress and that this person has the key to the kingdom of trading. It may or may not be true, but this is not where to begin your trading career.
You must protect yourself from overtrading, which can bring your career to an abrupt end. If you put yourself in the wrong atmosphere, meaning the casino atmosphere, you will be caught up in the phony ca- maraderie common to soldiers or contact sports teams. Members worry about appearing weakif they show fear of getting injured—in this case, of losing money. They appear to shrug off losses as immaterial, but a day or two later their chair is empty or someone else is using it.
Should you begin trading on a public floor? And if so, how should you go about selecting the right floor? As I see it, you have 21⁄2choices about where to trade. First, of course, is on a public trading floor. Choice number two is at home, or at an office, by yourself. The last one, which I characterize as half a choice, is with a group of friends or a trading club. I dub it a half choice since there are not many trading clubs that are successful.
I’ll discuss each choice briefly, but first let me review what is required to trade using computerized direct access to the stockor futures market via the Internet. For short, I’ll refer to this type of trading as direct access