CHAPTER FOUR Trading Rules

WHEN a person contemplates an extensive trip, one of the first things taken into account is the expense involved.

In planning our excursion into the realms of day trading we must, therefore, carefully weigh the expenses, or fixed charges in trading.

Were there no expenses, making a profit would be far easier - profits would merely have to exceed losses.

Whether you are a member of the New York Stock Exchange or not, in actual trading - profits must exceed losses and expenses. These are incurred in every trade, whether it shows a gain or a loss They consist of:

  • Commissions
  • Invisible eighth (i.e. the difference between bid and ask price, assuming that you buy and sell at the market price)
  • Income Tax on sale
  • Exchange fees
In addition interest if the trade is carried over night.

By purchasing a New York Stock Exchange seat, the commission can be reduced to $1 per hundred shares, if bought and sold the same day, or $3.12 if carried over night. This advantage is partly offset by interest on the cost of the seat, dues, assessments, etc.

The "invisible eighth" is a factor that no one - not even a member - can overcome. The bid and asked price is never less than an eighth apart. If the market is 45ź to 3/8 when you buy, you will as a rule, pay 45 3/8. Were you to sell it would be at 45 ź. This hypothetical difference follows you all through the trade and has been designated by the writer as the "invisible eighth". The Tape Reader who is a non-member of the exchange must, therefore, realize that the instant he gives an order to go long or short 100 shares, he has lost an eighth of a point. In order that he may not fool himself, he should add his commissions to his purchase price, or deduct them from his selling price immediately. People who boast of their profits usually forget to deduct expenses. Yet it is this insidious item that frequently throws the net result over to the debit side. The expression is frequently heard, "I got out even, except for the commissions," the speaker evidently scorning such a trifling consideration. This sort of self-deception is ruinous, as will be seen by computing the fixed charges on a trade of 100 shares. Bear in mind that a loss of the commission on the first trade leaves double that amount-to be made on the second trade before a dollar of profit is secured.

It therefore appears that the Tape Reader's problem is not only to eliminate losses, but to cover his expenses as quickly as possible. If he has a couple of points profit in a long trade, there is no reason why he should let the stock run back below his net buying price. Here circumstances seem to call for a stop order, so that no matter what happens, he will not be compelled to pay out money. This stop should not be thrust in when net cost is too close to the market price. A small reaction must be allowed for. A Tape Reader is essentially one who follows the immediate trend. An expert can readily distinguish between a change of trend and a simple, minor reaction.

When his mental barometer indicates a change he does not wait for a stop order to be caught, but cleans house or reverses his position in an instant. The stop order at net cost is, therefore, of advantage only in case of a reversal which is sudden and pronounced. A stop should also be placed if the operator is obliged to leave the tape for more than a moment, or if the ticker suddenly is out of order. While he has his eye on the tape the market will tell him what to do. The moment this condition does not exist he must act as he would if temporarily stricken blind - he must protect himself from forces which may attack him in the dark.

I know a trader who once bought 500 shares of Sugar and then went out to lunch. He paid 25 cents for what he ate, but on returning to the tape he found that the total cost of that lunch was $5,000 and 25 cents! He had left no stop order, Sugar went down ten points, and his broker sent him a margin call.

The ticker has a habit of becoming incoherent at the most critical points. Curse it as we may, it will resume printing intelligibly when the trouble is overcome - not before. As the loss of even a few quotations may be important, a stop should be placed at once and left in until the flow of prices is resumed.

If a trade is carried overnight, a stop should be entered against the possibility of accident to the market or the trader. An important event may develop before the next day's opening by which the stock will be violently affected. The trader may be taken ill, be delayed in arrival, or in some way be incapacitated. A certain allowance must be made for accidents of every kind.

As to where the stop should be placed under such conditions, this depends upon circumstances. The consensus of shrewd and experienced traders is in favour of two points maximum gross loss on any one trade. This is purely arbitrary, however. The Tape Reader knows, as a rule, what to do when he is at the tape, but if he is separated from the market by any contingency, he will he obliged to fall back upon the arbitrary stop. A closer stop may be obtained by noting the "points of resistance" in a stock - the levels at which the market turns after a reaction. For example, if you are short at 130 and the stock breaks to 128, rallies to 129, and then turns down again, the point of resistance is 129. The more time it turns at 129 the stronger the case you have. In case of temporary absence or interruption to the service, a good stop would be 129ź or 129ź. These "points of resistance" will be more fully discussed later.

If the operator wishes to use an automatic stop, a very good method is this: Suppose the initial trade is made with a one-point stop. For every ź pt. the stock moves in your favour, change the stop to correspond, so that the stop is never more nor less than one point away from the extreme market price. This gradually and automatically reduces the risk, and if the Tape Reader be at all skilful, his profits must exceed losses. As soon as the stop is thus raised to cover commissions, it would seem best not to make it automatic thereafter, but let the market develop its own stop or "signal" to get out.

One trouble with this kind of a stop is that it interferes with the free play of judgment. An illustration will explain why: A tall woman and a short man attempt to cross the street. An automobile approaches. The woman sees that there is ample time in which to cross, but he has her by the arm and being undecided himself backs and fills, first pushing, then pulling her by the arm until they finally return to the curb, after a narrow escape. Left to herself, she would have known exactly what to do. It is the same with the Tape Reader. He is hampered by an automatic stop. It is best that he be free to act as his judgment dictates, without feeling compelled by a prior resolution to act according to hard and fast rule.

There is another time when the stop order is of value to the Tape Reader, viz., when his indications are not clearly defined. The original commitment should, of course, be made only when the trend is positively indicated, but situations will develop when he will be uncertain whether to stand pat, close out, or reverse his position. At such a time it seems better to push the stop up to a point as close as possible to the market price, without choking off the trade. By this we mean a reasonable area should he allowed for temporary fluctuations. If the stock emerges from its uncertainty by going in the desired direction, the stop can be changed or cancelled. If its trend becomes adverse, the trade is automatically closed.

Fear, hesitation and uncertainty are deadly enemies of the Tape Reader. The chief cause of fear is over-trading. Therefore commitments should be no greater than can be borne by one's susceptibility thereto. Hesitation can be overcome by disciplined self-training. To observe a positive indication and not act upon it is fatal - more so in closing than in opening a trade. The appearance of a definite indication should be immediately followed by an order. Seconds are often more valuable than minutes. The Tape Reader is not the captain - he is the engineer who controls the machinery. The Tape is the pilot and the engineer must obey orders with promptness and precision.

We have defined a Tape Reader as one who follows the immediate trend. This means that he pursues the line of least resistance. He goes with the market - he does not buck it. The operator who opposes the immediate trend pits his judgment and his hundred or more shares against the world's supply or demand and the weight of its millions of shares. Armed with a broom, he is trying to keep at bay the incoming tide. When he goes with the trend, the forces of supply, demand and manipulation are working for and with him.

A market which swings within a radius of a couple of points cannot be said to have a trend, and is a good one for the Tape Reader to avoid. The reason is - unless he catches the extremes of the little swings, he cannot pay commissions, take occasional losses and come out ahead. No yacht can win in a dead calm. As it costs him nearly half a point to trade, each risk should contain a probable two or five points profit, or it is not justified.

A mechanical engineer, given the weight of an object, the force of the blow that strikes it, and the element through which it must pass, can figure approximately how far the object will be driven. So the Tape Reader, by gauging the impetus or the energy with which a stock starts and sustains a movement, decides whether it is likely to travel far enough to warrant his going with it - whether it will pay its expenses and remunerate him for his boldness. The ordinary speculator trading on tips gulps a point or two profit and disdains a loss, unless it is big enough to strangle him. The Tape Reader must do the opposite - he must cut out every possible eighth loss and search for chances to make three, five and ten points. He does not have to grasp everything that looks like an opportunity. It is not necessary for him to be in the market continuously. He chooses only the best of what the tape offers.

His original risks can be gradually effaced by clever arrangement of stop orders when a stock goes his way. He may keep these in his head or put them on the "floor." For my own part I prefer, having decided upon a danger point, to maintain a mental stop and when the price is reached close the trade "at the market." Reason: There may be ground for a change of plan or opinion at the last moment; if a stop is on the floor it takes time to cancel or change it, hence there is a period of a few minutes when the operator does not know where he stands. By using mental stops and market orders he always knows where he stands, except as regards the prices at which his orders are executed. The main consideration is, he knows whether he is in or out.

The placing of stops is most effectual and scientific when indicated by the market itself. An example of this is as follows:

Here a stock, fluctuating between 128 and 129, gives a buying indication at 128 3/4.

Obviously, if the indication is true, the price will not again break 128, having met buying sufficiently strong to turn it up twice from that figure and a third time from 128 1/8. The fact that it did not touch 128 on the last down swing forecasts a higher up swing; it shows that the downward pressure was not so strong and the demand slightly larger and more urgent. In other words, the point of resistance was raised 1/8. Having bought at 128 3/4, the stop is placed at 127 7/8, which is ź below the last point of resistance. The stock goes above its previous top (129 1/8) and continues to 130 3/4. At any time after it has crossed 130 the trader may raise his stop to cost plus commission (129). The stock reacts at 129 7/8, then continues the advance to above 131. As soon as a new high point is reached the stop is raised to 129 5/8, as 129 7/8 was the point of resistance on the dip. In such a case the initial risk was 7/8 of a point plus commissions, etc the market giving a well defined stop point, making an arbitrary stop not only unnecessary but expensive.

The illustration is given in chart form, but the experienced Tape Reader generally carries these swings in his head. A series of higher tops and bottoms are made in a pronounced up swing and the reverse in a down swing. Arbitrary stops may, of course, be used at any time, especially if one wishes to clinch a substantial profit, but until a stock gets away from the price at which it was entered, it seems best to use the stops it develops for itself.

If the operator is shaken out of his trade immediately after entering the trade, it does not prove his judgment was wrong. Some accident may have happened, some untoward development in a particular issue, of sufficient weight to affect the rest of the list. It is these unknown occurrences that make the limitation of losses most important. In such a case it would he folly to change the stop so that the risk is increased. This, while customary with the general investing public, is something a professional Tape Reader seldom does. Each trade is made on its own basis, and for certain definite reasons. At the outset the amount of risk should be decided upon, and, except in very rare instances, should not he changed, except on the side of profit. The Tape Reader must eliminate, not increase, his risk. Averaging does not come within the province of the Tape Reader. Averaging is groping for the top or bottom. The Tape Reader must not grope. He must see and know, or he should not act.

It is impossible to fix a rule governing the amount of profit the operator should accept. In a general way, there should be no limit set as to the profits. A deal, when entered, may look as though it would yield three or four points, but if the strength increases with the advance it may run ten points before there is any sign of halt. We wish our readers to bear fully in mind that these recommendations and suggestions are not to be considered final or inflexible. It is not our aim to assume the role of an oracle. Rather, we are reasoning things out on paper, and as we progress in these studies and apply these tentative rules to the tape, in actual or paper trading, you probably have occasion to modify some of our conclusions.

A Tape Reader must close a trade: 1) when the tape tells him to close; 2) when his stop is caught; 3) when his position is not clear; 4) when he has a large or satisfactory profit and wishes to utilize those funds for better opportunities.

The first and most important reason for closing a trade is: The tape says so. This indication may appear in various forms. Assuming that one is trading in a Leader stock, the warning may come in the stock itself.

Within the recording of sales, there runs the fine silken thread of the trend. It is clearly distinguishable to one sufficiently versed in the art of Tape Reading, and, for reasons previously explained, is most readily observed in the leaders. So, when one is short of Union Pacific and this thread suddenly indicates that the market has turned upward, it's foolish to remain short. Not only must one cover quickly, but if the power of the movement is sufficient to warrant the risk, the operator must go long. In a market of sufficient breadth and swing, the Tape Reader will find that when it is time to close a trade, it is usually time to reverse his position. One must have the flexibility of whalebone, and entertain no rigid opinion. He must obey the tape implicitly. The indication to close a trade may come from another stock, several stocks or the general market.

For example, on the day of the Supreme Court decision in Consolidated Gas, suppose the operator was long of Union Pacific at 11 o'clock, having paid therefore 182 ž. Between 11 and 12 o'clock Union rallied to 183 1/2, and Reading, which was more active, to 144. Just before, and immediately after, the noon hour, tremendous transactions took place in Reading, over 50,000 shares changing hands within three-quarters of a point. These may have been largely wash sales, accompanied by inside selling; it is impossible to tell. If they were not, the inference is that considerable buying power developed in Reading at this level and was met by selling heavy enough to supply all bidders and prevent the stock advancing above 144 3/8.

Large quantities coming within a small range indicated either one of two things: 1) That considerable buying power suddenly developed at this point, and the insiders chose to check it or to take advantage of the opportunity to unload. 2) The demonstration in Reading may have been intended to distract attention from other stocks in which large operators were unloading (there was no special evidence of this, except in New York Central). If the selling was not sufficient to check the upward move, the market for Reading would have absorbed all that was offered and advance to a higher level, but in this case the selling was more effectual than the buying, and Reading fell back, warning the operator that the temporary leader on the bull side of the market had met with defeat. At this point the operator was, therefore, on the lookout for a slump. Reading subsided, in small lots, back to 143 7/8. Union Pacific, after selling at 183 5/8, declined to 183 ź. Both stocks developed dullness, and the whole market became more or less inactive.

Suddenly Union Pacific fell to 183 1/8. Then UP traded 500 shares @183, 200 at 182 7/8, 500 at 183, 200 at 182 7/8, and 500 at 182 3/4, indicating not only a lack of demand, but remarkably poor support. Immediately following this, New York Central, which sold only a few minutes before 400 shares at 131˝ came 131 on 1700 shares, 130ź on 500 shares and ended at 130 on 700 shares. This demonstrated that the market was remarkably hollow and in a position to develop great weakness. The large quantities of New York Central at the low figure, after a running decline of a point and one-half, showed that there was not only an absence of supporting orders, but that sellers were obliged to make great concessions in order to dispose of their holdings. The quantities, especially in view of the narrowness of the market, proved that the sellers were not small traders. Coupled with the wet blanket put on Reading and the poor support in Union Pacific, this weakness in New York Central was another advance notice of a decline.

On any indication of this kind, the trader must be ready to jump out of his long stock and get short of the market. While waiting for his cue, the Tape Reader has time to consider which stock among the leaders is the most desirable for selling. He quickly chooses Reading, on the ground that the large lots which have apparently been distributed around 144 will probably come into the market as soon as weakness develops. Reason: The general investing public generally buys on just such peaks as the one which has taken place in Reading. A large volume, even if accompanied by only a fractional advance, has the effect of making the ordinary trader intensely bullish, the result being that he bites off a lot of long stock at the top of the market. This is exactly what the manipulator wishes him to do. We have all heard people boast that their purchase was at the top eighth and that it had the effect of turning the stock down. Those who make their purchases after this fashion are quickest to become scared at the first sign of weakness, and throw overboard what they have bought. First greed and then fear controlled them. In choosing Reading, therefore, the Tape Reader is picking out the stock in which he is likely to have the most help on the bear side.

At 12.30 PM the market is standing still, the majority of transactions being in small lots and then only fractional changes. Reading shows the effect of the recent unloading. It is coming out 500 at 143 3/4, 500 at 143 5/8, 400 at 143 ˝ and 400 at 143 3/4. The operator realizes that Reading is probably a short sale right here, with a stop order at 144 1/2 or 5/8, on the ground that the bulls must have an extraordinary amount of buying power to push the stock above its former top, where, at every eighth advance over 144 3/8, they will encounter a considerable portion of 50,000 shares.

This reasoning, however, is all aside from our main argument, which is to show how the clue to get out of the stock will be given by the action of stocks other than that in which the trader is working. Union Pacific shows on the tape in small lots at 182 3/4; New York Central 1100 at 130, and 900 at 130 3/8. The rest of the market seems to have all the snap and ginger taken out of it and the operator does not like his position on the long side. He has no definite indication to sell short, however, he feels that his chances on the long side have been reduced to practically nothing by the weak undertone of the market, he therefore gets out of his Union Pacific and waits until the tape tells him to sell Reading short. Union Pacific weakens to182 5/8. The others slide off fractionally. The weakness is not strong enough to forecast any big break, so he continues to wait. There are 1800 shares of Union altogether at 182 5/8, followed by 3000 at 182 1/2. Other stocks respond and the market looks more bearish. Consolidated Gas trades 163ž - 163 ź - 163. This is the first sign of activity in the stock, but the move is nothing unusual for Gas, as its fluctuations are generally wide and erratic. The balance of the list rallies a fraction. Gas trades 162 ˝ to ž, then 500 at 162 1/4. At this point Gas, which has been very dull up to now, forces itself, by its decline and weakness, upon the notice of the operator. He begins to look upon the stock as the possible shears which will cut the thread of the market and let everything down.

12.45 PM Gas trades 500 at 161 1/2. It is very weak. The balance of the list is steady, Union Pacific 182 5/8, Central 130 3/8, Reading 143 3/4. There is a fractional rally - Union Pacific to 182 7/8 and Gas to 162. Plenty of Central for sale around 130; Reading is 143 1/2. The rally peters out gradual weakening all around, but the Tape Reader cannot go with the trend until he is sure of a big move. Central trades at 129ž, showing that after all the buyers at 130 are filled up considerable stock is still for sale. The others show only in small lots. The market is on the verge of a decline; it is where a jar of any sort will start it down. Union Pacific is heavy at 182 1/2 - trades 300 at 182 3/8, 200 at 1/2; Reading 143 1/2, 3/8, and 1000 shares at 1/2; Central trades 2000 at 130 and 800 at 1/8.

Here is the thrust he has been looking for! Gas 163ž on 200, 1/2 on 400, 161 on 300, 160 on 400! He waits no longer and gives an order to sell Reading short at the market. They are all on the run now, Reading 143 1/2, 600 at ź, 1300 at 1/4. Central 130, 129 1/2, Gas trades 500 at 159 1/2. Something's very rotten about Gas and it's a cinch to sell it short if you don't mind trading in a buzz-saw stock. The market breaks so rapidly that he does not get over 142 3/4 for his Reading, but he is short not far from the top of what looks like a wide open break. Everything is slumping now - Steel, Smelters, Southern Pacific, St. Paul. Union Pacific is down to 181 5/8 and the rest in proportion. Gas 158 1/2,158 on 300, 157, 156, 155, 154, 153 and the rest "come tumbling after." Reading 141 3/8, 500 at ź, 400 at 141, 140 3/4, 500 at 1/2, 200 at 140, 600 at 139 3/4, 500 at 5/8. Union 181 - 180 7/8, 3/4, 1/2, 1/4, 600 at 1/8, 500 at 180, 179 3/4, 500 at 1/2, 300 at 1/4, Central 127 1/2.

The above illustrates some of the workings of a Tape Reader's mind; also how a break in a stock, entirely foreign to that which is being traded in, will furnish an indication to get out and go short of one stock or another. The indication to close a trade may come from the general market where the trend is clearly developed throughout the list all stocks working in complete harmony. One of the best indications in this line is the strength or weakness on rallies and reactions.

Of course the break in Gas, which finally touched 138, was due to the Supreme Court decision, announced on the news tickers at 1:10 PM, but, as is usually the case, the tape told the news many minutes before anything else. This is one of the advantages of getting your news from the first place where it is reflected. Other people who wait for such information to sift through telephone wires and reach them by the roundabout way of news tickers or word of mouth, are working under a tremendous handicap. That not even the insiders knew what the decision was to be - is shown in the dullness of the stock all morning. Those who heard the decision in the Supreme Court chamber doubtless went straight to the telephone and sold the stock short. Their sales showed on the tape before the news arrived in New York. Tape Readers were, therefore, first to be notified. They were short before the Street knew what had happened.