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Additional Day Trading Concepts

If you are going to take day trading with stocks seriously (like a business), then you must learn other things that you will be constantly exposed to like, Level II, ECNs, Market Makers, order routing, and technical analysis. (I think that day trading with currencies is a lot simpler than with stocks. The only information on this page that applies equally to currencies is in the “Technical Analysis” section. If you want to read the rest of the basic material that you have to become familiar with to learn how to trade currencies, click here).

Level II

In the previous section, I talked about level I, which includes the best bid and ask (best prices) for a stock at a given time. This information is just the tip of the iceberg. Level II does not only show you the best bid and ask prices, it shows you all the prices (bids and asks) available for a stock. This is extremely important information because it helps a trader get a much better sense of where to place his or her order (based on available volume at different prices). It also provides a better indication of the short-term momentum of the stock.

Level II provides the number of shares at each available price level for a stock, as well as through which institution or electronic system the shares are being offered. Using a direct access broker and a program like RealTick, a trader can then choose which institution or electronic system to use to place the order (look at the order routing section below). A simplified example of level II is as follows:

Level II Example

Intel Corporation
(Ticker: INTC)
Name Size BID   Name Size ASK
ISLD 1000 34.24   NITE 200 34.26
GSCO 200 34.23   ISLD 5000 34.27
ARCA 400 34.21   JPMS 2000 34.28
MLCO 800 34.19   REDI 700 34.29

On the left side of the table are the open buy limit orders (Bids) arranged from highest to lowest (best to worst). On the right side are the ASK prices, which are open sell limit orders arranged from lowest to highest (best to worst). Level II software like RealTick color codes each price level to make it easier to read. The “Name” column gives a four letter symbol of the institution (ex: Goldman Sachs has an open order to buy 200 shares of INTC at 34.23 or lower) or the electronic system (ex: ISLD has an open sell order for 5000 shares at 34.27) that’s quoting a price. The best bid and ask is given by the top color level (blue in this example). In the above example, the best bid is 34.24 and the best ask is 34.26. This is usually the only information (best bid and ask) that a person using an online broker or a full-service broker normally gets to see. Level II, on the other hand, gives the entire picture (or depth) of the market at any given time.

ECNs (Electronic Communication Networks)

NOTE: Since the 1990s, ECNs have had quite a makeover (for example, Island [ISLD] was acquired by Instinet [INCA] in 2002, forming the end-product INET, which was eventually acquired by NASDAQ in 2005). As a result, the Level II examples in this section are not to be taken literally and are only provided for informational purposes only and to understand the functionality behind order routing.

So far I have mentioned that level II shows the institutions and electronic systems that have open orders for a stock. The formal name for these electronic systems is “electronic communication network” or ECN. An ECN is a computerized system that matches orders for buyers and sellers of a stock. Since ECNs work electronically, executions through ECN’s are usually lightning fast (a fraction of a second) – and this is one of their big advantages. A direct-access broker gives traders access to ECNs through the trading software they provide. RealTick is an example of this type of software. The first ECN was Instinet (symbol INCA on level II), which was created in 1969 and was used for a long time to allow only institutions to place orders through it. Instinet eventually opened its doors to individual investors and traders decades after its launch because of the pressure it experienced in the form of lost business to the newer, and more competitive ECNs, like ISLAND (who Instinet eventually acquired [see note at the beginning of this section]. At this point in time ISLAND is probably the ECN that is most widely-used by equity traders, and, according to the National Association of Securities Dealers (NASD), Island traded more shares of NASDAQ securities than any other ECN; executing 10.1% of total NASDAQ share volume during December 2001 (in second place was Instinet with 9.2%).

Investors that use online or full-service brokers to day trade do not normally have direct access to individual ECN’s. This is a big disadvantage and one that will become more and more apparent to you when you experience the power of trading through a direct-access platform.

Market Makers (institutions)

Other than ECN’s, there are institutions that appear on level II that are called “market makers.” You can think of market makers as professional traders that are employed by big institutions (like Goldman Sachs and Merrill Lynch). Market makers are out there to make money (just like we are) and they have special benefits bestowed upon them by the NASD (who regulates them), since they are supposed to bring volume to the market for NASDAQ stocks. Market makers trade for the firm’s account (for example, buying shares at the bid and selling them at the ask to make the difference) or they can execute orders for the firm’s clients, who could be small individual investors or large institutional investors like mutual funds. Even though every broker is supposed to try to obtain the “best” available price in the market for their clients, most online brokers send the majority of their orders to a given market maker that gives them a rebate for doing so (this is called “payment for order flow” and is a much debated topic because of the conflicts of interest that it creates). The broker’s clients have no say in where their broker sends their order, a huge disadvantage that investors who trade using a direct-access trading system don’t have.

Order Routing

Order routing is the process of choosing which system to send the order through (ECN, market maker, etc., etc.). Unfortunately, this is not a choice that can be made by people who day trade through an online broker (ex: Charles Schwab) or a full-service broker (ex: Merrill Lynch). The investor who uses direct access, on the other hand, does have to decide which ECN to use or which market maker to trade against. For traders who are coming from the traditional online world and are used to simply specifying which stock they want to buy and how many shares, order routing might be a bit overwhelming at first; but once they learn how to read level II and how the major ECN’s work, it will become extremely easy and they will begin to wonder how they ever survived without it.

Order routing is extremely important and, unfortunately, overlooked often by new traders and instructors who claim to teach people how to trade. Please make sure that you have a strong enough grasp of this subject before you start using a direct-access system to trade or invest.

Technical Analysis

As I have mentioned before, a stock should not be held for more than one day unless the investor performs a complete fundamental analysis on the company (which is beyond the scope of this website). On the other hand, if a person is planning to get rid of all his or her stock positions before the trading day is over, then I think the most important thing to learn is technical analysis. Technical analysis takes a look at past stock prices (in the form of a chart) to try to determine what the price is likely to do next. Technical analysis can be applied using the KISS (keep it simple students) principle or it can be complicated beyond belief with advanced mathematics and calculations.

Despite the fact that I have a B.S. Degree in Electrical Engineering, and Engineers love math, I must admit that I prefer the simple method. For that reason, the technical analysis I use is very straightforward and it is based on the concepts of trading around “support” and “resistance” and basic indicators. Furthermore, the simpler something is, the easier it can be mastered. To succeed, a day trader must have the complete control and mental security that comes with complete mastery of his trading system (NOTE: I have nothing against advanced technical analysis; I work with traders who use it successfully).

In technical analysis, “support” is a price level on a chart where a stock bounces up from. Generally, demand (buying pressure) overtakes supply (selling pressure) at a stock’s support level causing the stock to go up. “Resistance” is the other way around. When a stock is rising, eventually it reaches a price level from which it is repelled. Simply put, supply outweighs demand and the stock tends to fall in price. A simple example of this is provided below using a 3-month daily chart of McDonald’s Corporation (ticker symbol MCD):

Day trading graph with support and resistance.

Notice that during the last three months on the chart, McDonald’s stock has been repelled (downward pressure) when its price price has gotten close to 27.50, and that the stock has bounced from a support level near 25.50 more than once. Notice that the stock did not go perfectly up to the 27.50 level or down to the 25.50 level. That’s because technical analysis is not perfect. Once you have enough practice, you will be better prepared to make logical decisions based on it.

To perform a complete technical analysis of a stock, the trader can look at a chart of the last several years, then at a one-year chart, then at a six-month chart, then at a one-month chart, then at a chart covering several days, and finally at a chart of the current trading day, known as an “intraday chart”. By doing this, the trader will get an idea as to where the critical levels in price are that might represent resistance or support for the stock. The system or methodology that the trader uses should then take advantage of these critical levels and trade around them.

So once you learn how to read and use level II, how the major electronic communication networks (ECNs) work, where to send your order (order routing), and how to use technical analysis to trade stocks (or currencies), you will be better prepared to take on day trading as a business.

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