Section 2: Tools of the Trade

Trading is like any other endeavor or profession where certain tools are required. This chapter outlines the minimum set of tools you will need to become a successful trader.

There are three general categories of tools:

• Brokerage account. This not only includes an online broker, but also financial considerations such as how much to start with, what type of account should you open, and how much to commit to each trade.
• Streaming quotes and intra-day charts. Streaming quotes are stock quotations that change dynamically, in real-time and without delay, reflecting every trade made for a stock—right when it happens. Intra-day charts are stock graphs that show trading action, including the volume of shares traded, from the beginning of the trading session to the current moment. A good, intra-day chart should have no delay (the information should be up to the second), and the chart intervals can be from 1 minute to 30 minutes apart.
• News wire and media services. This can be any reliable source of financial news and current events. To be useful for trading, the news reporting should have minimal delay (no more than a few minutes after an event has occurred).

 

 

You can't possibly trade stocks or options unless you have a brokerage account, and for trading, you need to be able to place buy and sell orders directly on your computer (not through a live broker that you call on the phone, etc.).

 

Online brokers are fairly competitive, many of them offer a number of bells, whistles and other incentives to lure your business, but what is truly important for trading might be different than what their promotional offers imply. Even if you already have an established account, be sure that it meets the minimum criteria outlined below.

 

While each online broker has its own strengths and weaknesses, opening up an account is pretty much the same. Basically, you:

1. Fill out paperwork with personal and financial information, and attest that you understand the risks and that you know what you are doing, etc. For options trading, most brokers require that you complete an additional form, attesting that you understand the risks and perils of options, and that you have enough experience to avoid being destroyed (more on this below).
2. Submit the completed forms with some method of payment to fund the account. Keep in mind that most brokers hold these funds for several days, especially if you fund the account with a personal check, and even certified funds (cashier's checks, money orders, etc.) might be subject to a hold; these policies may vary between brokers.
3. Get assigned a username and password (if not assigned already) to access your account from your computer.

Essentially, your brokerage account is a bank account from which you can make trades, deposits and withdrawals (some brokers even provide a checkbook and ATM card).

 

Margin versus Cash

 

Most brokers offer two types of accounts: a cash account, or a margin account. A cash account is an account that lets you trade up to your cash value, but no more. A margin account lets you trade approximately twice your account's cash value, because the broker can lend you money against your stock that you have purchased.

 

For instance, let's say you opened up an account for $5,000, and you buy $5,000 worth of stock. If you opened a margin account, the broker will lend you up to $5,000 to buy more stock, which gives you the total buying power of $10,000.

 

Margin accounts have the advantage of doubling your buying power, but margin does not apply to options trading. For options, you can only use your cash balance.

 

It is recommended that you open a margin account, if possible, even if you do not intend to use your margin, and even if you intend to trade only options. The reason is that a margin account can offer additional benefits. For instance, some brokers let you draw funds against unrealized gains on a margin account (gains on stock purchases that you have not realized yet by selling the stock). Additionally, sometimes you won’t get instant credit selling stock or options without a margin account (some brokers won’t credit you with the profits for three days after a sell without a margin account).

 

Options Trading

 

Regardless of which broker you choose, do not assume that options trading services are automatically available. Usually, the broker requires “approval” for options trading. This requires that you complete a special form, and that you specify that you want the ability to buy options.

 

Part of this special form asks about your trading experience (which, of course, you attest that you do have experience after practice trading the material in this book). Some brokers make you sign an affidavit that you know what you are doing, and that you aren’t a helpless widow or orphan, and a number of other attestations. (Don’t worry, options trading is no more risky than ordinary trading, provided that you apply the proper trading disciplines).

 

If you already have a trading account, you still have to get “approval” for options, which will also require you to complete the same form.

 

Options “Status”

 

Some brokers offer various “levels” of options approval, and in some cases, you need to specify which level you want. The minimum level must be the ability to buy call and put options. Some brokers will ask if you want to write covered calls, which means that you will be able to sell option contracts against stocks that you already own (you can say “yes,” although this particular strategy is not covered in this book).

 

Choosing a Broker

 

For options trading, it is best to go with one of the “big three,” which are Ameritrade, Scottrade and E*Trade. Each of them have different minimums to open an account, and each have a different commission structure for options. As noted above, you must specify that you want options trading status when the account is first opened.

 

The following table shows a comparison between each of these three brokers.

 

Broker	Internet Link	Minimum	Commissions
Ameritrade	www.ameritrade.com	$2,000	$10.99 +1.50 per contract
Scottrade	www.scottrade.com	$500	*$7/$12 + 1.50 per contract
E*Trade	www.etrade.com	$1,000	$19.95 + 1.75 per contract

*Scottrade charges different commissions for a market order versus a limit order. A market order is when you buy or sell at the best price the broker can find, while a limit order is when you buy only at the price that you specify.

 

Commissions that you pay for options with each broker are based on a flat rate + some amount for each contract. A contract is 100 options.

 

Other Brokers

 

There are many other reputable online brokers, for both small and large accounts alike, yet we are only recommending the firms with which we have some familiarity. It is very possible that you already have an account with a broker, or are interested in one that is not mentioned, which is perfectly acceptable. If so, use the following checklist to determine their suitability to trade (don't pay attention to any of their hyped promotion, use only the guidelines below).

1. Availability of options trading. It is imperative that you are able to trade options. Do not assume that the broker you are interested in provides options trading---some do not.
2. Commission prices. Don't pay more than $20 per trade (+ no more than $2.00 per contract), or you will lose too much money to the broker. Remember that commissions are charged for each buy and sell.

3. Availability of funds. This is often an overlooked feature, but if you make a little money, how easy is it to withdraw funds? Check on the banking features, as some of the better brokers provide checkbooks and even ATM cards. If you make a decent profit, you might want easy access to the funds in your account.

 

Order Terminology

The mechanics of placing buy and sell orders for options is a fairly straightforward process once you understand the terminology.

 

Buy/Sell Options. The only two radio buttons you will be interested in are Buy to Open and Sell to Close. The other two (Buy to Close and Sell to Open) are only used when you are selling contracts against stock that you already own (which we do not recommend). Buy to Open means you want to buy one or more options contracts (calls or puts), and Sell to Close means you want to sell one or more options contracts that you own.

 

Number of Contracts. This is where you enter the number of option contracts to be bought or sold. An option contract is 100 options. In other words, an entry of “1” means 100. Be careful about this, because if you enter “100,” that would mean 10,000 options (which is probably not what you wanted if you are trading for low stakes).

 

Condition. I do not believe this is used unless you are selling contracts against stock that you own. But if it insists that you choose one, select Uncovered (which means that you do not own the underlying stock associated with these options).

 

Root. This is the first character(s) of the options symbol, which will be a one, two or three character symbol that represents the option.

 

[Date], Strike. This indicates the expiration date and the strike price of the option (the price for which you have the right, but not the obligation, to buy or sell the underlying stock).

 

Call, Put. One of these indicates whether you are buying a call option or a put option.

 

Market order / Limit Order (buttons). A market order tells the broker to buy or sell the option contract at the best available price at the time the order is made. A limit order tells the broker to buy or sell only at the specified price (if you choose Limit Order, you will be asked to indicate the price).

 

 

Quote Streamers

 

A quote streamer is a software program (or in some cases, a web page) that displays trading activity for stocks in real time, exactly as they occur on the exchange, with essentially no delay. The term streamer is used because the data is received as a continuous stream, dynamically changing the desired stock quotations, as opposed to remaining unchanged until you "ask for a quote." A good quote streamer is mandatory for trading.

 

Typically, a quote streaming system is configurable in a spreadsheet-like format, as shown below.

   

Recommended Streamers

 

Most of the popular online brokers provide streaming quotes services, or at least they claim to. You might want to check with your broker (or potential broker) to see what features are available for streaming quotes. The minimum requirements are as follows.

 

Charting

 

Charting is the display of a stock's trading history, in a graphical format, showing recent trends and other characteristics of the stock. Charting is absolutely mandatory as a trading tool.

 

Most brokers that provide decent quote streamers will also provide reasonable charting. But charting is one tool that you really can't skimp on when it comes to trading; both daily and intra-day charts are an integral part to nearly every trading decision that you will make.

 

A daily chart is the historical representation of a stock's daily history (what it did each day for the last 6 months or so). An intra-day chart is an historical representation of what the stock did today, or the last few days. Intra-day charts will typically break down to 1, 2, 5, 15 or 30 minute intervals.

 

   A daily chart (above), courtesy of eSignal.

Daily Charts

 

A daily chart is an essential tool for locating potential trades, mainly because it shows the current trend of the stock and its likely direction can be accurately estimated. The above example shows the performance of ACXM for the last six months; the red and blue bars near the bottom indicate the trading volume for each day (red indicates more selling than buying, while blue indicates more buying than selling).

 

If you don't fully understand everything about this chart, don't worry — chart analysis is covered in a later section.

 

Intra Day Charts

 

An intra-day chart differs from a daily chart in that its performance is broken down to small intervals such as 1, 2, or 5 minutes. Intra-day charts are essential to predict the likely direction that a stock will take during the trading session; it also helps determine how the stock is likely to perform at the open of the next trading session.

 

Intra-day chart (above), courtesy of eSignal.

 

Two-Tone

 

A two-tone chart means that a different color is used for + and - directions of price and volume. In the above two examples, for instance, blue line(s) indicate an upward direction, while red lines indicate a downward direction. With regard to volume (the vertical bars near the bottom of the chart), a blue bar indicates "up" volume (more buyers than sellers), while red indicates "down" volume (more sellers than buyers). Two-tone charts are helpful for effective stock trading, although not absolutely required.

 

Affordable Streamers and Charters

 

If your broker does not provide adequate streamer and/or charting features, you can always subscribe to services that provide these tools. However, most stand-alone streaming services are relatively expensive, especially if you are trading with low stakes. Esignal (www.esignal.com), for instance, is one of the very best services, but subscriptions begin around $100/month for a bare-bones set of features. Most other standalone streaming services are equally as expensive.

 

Fortunately, I know of one service that is rather inexpensive (a minimum system runs about $14.95/month), and you can find them at www.money.net.

 

Money.net Streamer (above), a good quote streamer with decent charting, for $14.95 per month.

 

Money.net’s affordable streamer also has some decent charting capabilities, including two-tone options.

 

 

Although money.net has a few “clunky” elements, and although it is not as powerful as eSignal, I do not believe there is any better bargain for streaming quotes and charts on the Internet. It deserves consideration.

 

News

 

One or more reliable sources of financial news is essential to trading. Unlike brokers and quote streamers, most of the best sources for news are free, and these sources are outlined below.

 

Working the News

 

The primary reason you need access to financial news is to ascertain the reason for any unusual behavior in a stock. For example, one of the most effective trading techniques is to locate stocks that recently sold off, anticipating a bounce. To properly time the bounce, however, it is essential that you find out why the stock sold off in the first place. If the reason for the sell-off is unwarranted, chances are it will bounce sooner than if the reason is more devastating to the stock or the underlying company.

 

Precise methods of assessing a stock's chance of a rebound, based on the news, is covered in more detail later in a later section.

 

A secondary reason for monitoring the news is to determine market sentiment. The market sentiment is the overall "mood" of the market, which frankly, can change on a dime. Assessing the market sentiment is a key component to successful trading. You need a reliable news source to learn what events are driving the market.

 

Finally, financial news sources are often useful to determine what market sectors and industry groups are in favor (what's hot and what's not). Such information is invaluable when determining potential trades from day to day.

 

Sources

 

Fortunately, most of the news sources you need for successful trading are free, or low-cost. Keep in mind that the purpose of a news source is to assess the reason a stock or the broader market is behaving in a certain manner, and not to obtain "stock tips".

 

Yahoo! Finance (finance.yahoo.com). This is one of the most reliable sources for up-to-date financial news and press releases that I have found anywhere, yet it is free of charge. By simply entering a stock symbol on Yahoo's financial page, you can get accurate news information for any publicly traded company.

 

CNBC (TV cable, available with most standard cable packages). For television, CNBC has more extensive financial coverage than any other cable or network channel. Beginning as early as 5AM-EST, and running into the early evening, CNBC covers stocks, bounds and futures, play-by-play. Personally, I have CNBC on all day long, from the moment I get up in the morning. While it doesn't provide any direct information about potential trades (as most information in this regard is misleading), CNBC is invaluable to assess the tone of the market, breaking news and general current events, especially those events that will affect the market direction.

 

Of particular interest on CNBC is their reporting of market futures, especially in the morning before the opening bell on the stock exchange. (Market futures reflect specialized trading on the speculation of future action of the major indices such as the Dow, S&P-500 and the NASDAQ). Market futures are a very accurate indicator of how the market will open.

 

IBD (Investor's Business Daily). Although not free, this publication is extremely useful  if you want to be a good trader. IBD has both printed and online publications (you get full access to their online publication when you subscribe to their printed publication).

 

In addition to their publication, IBD's web site (www.investors.com) has fee-based screening services, which are some of the best I have encountered. Using their own proprietary rating system, these screening tools can locate the stocks that are most favorable to big institutions. Some excellent trading candidates can be located with these screens.
 

 

Truth Revealed