Don Bright PortraitSince You Asked

with Don Bright

Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

Mr. Bright, one of my mentors uses the terms profit targets and stop-losses. I understand what he means by them, but he has never been able to convince me he has a tangible, practical way of determining what targets and losses should be. Do traders in your firm use these in their trading? — opentoitmich

These are basic terms used by most investors and some traders. Investors tend to use stop-losses more than those who actually make their primary living from active trading. The reason for this is simple: the active trader is more in tune with the marketplace, day by day. The investor is in it for the long term.

I asked around and came up with an article that might help you. I will attribute it to Dennis Dick, who is a Bright Trading trader and a Chartered Financial Analyst (CFA). Dennis wrote a nice article called “Leave Yourself Some Outs” recently:

  1. Be disciplined. Okay, sure, we’ve heard that our whole trading lives, right? But what does it mean? Let’s put it this way — if you’re not disciplined, then nothing else matters.
  2. Set a good risk/reward ratio. Going back to my days on the option trading floor, we used this concept. We actually had our computer-generated trading sheets print this ratio out for us to see. But in the equities trading world, we must try hard to determine ahead of time what we are willing to risk.

For instance, a short-term daytrader making five- to 10 cents on a winning trade should not be losing 40 to 50 cents on losing trades, Dennis explained, going on to say: “I always try to employ a risk–return ratio of at least 2:1. If I’m willing to risk, say, one point on a particular trade, I will want to make two points on that same trade. Following this rule means I can be wrong two times for every time I’m right and still break even.”

In the 1990s, the NASDAQ market makers were the only ones who had access to Level 2. In the 2000s, everyone was given access, and the games that are played now came into being.Now on to something else that you need to understand about all this: trading time frames. At Bright Trading, we’re finding that more and more traders are holding for the longer term, days and weeks. Your same risk/reward ratios need to apply, no matter what your time frame. I often find trades putting on a position, perhaps a simple pair (long X, short Y) for a 10-cent debit. Simply, they entered the trade for a 30-cent credit for this pair. It could be from paying $77.27 for X, shorting Y for $77.57 as an example. They know from watching this pair that the trading range has been from a 40-cent debit to a 40-cent credit — an 80-cent range. They are assuming that the pair should not lose more than 10 cents, with a possible profit of up to 70 cents.

But most traders would prefer to make 30 cents, 40 cents a few times, all within that same trading range, instead of holding and hoping for the full 70–80 cents. This time frame will allow for daytrading to weeks-long holding periods. So something that makes sense is simple: 10-cent stop-loss, 30-cent profit target. Hope this helps.

Mr. Bright, I know one of your traders and he tells me that I am wasting my money using Level 2 NASDAQ. But I was taught that we can tell how weak or strong the market is by checking the number of shares bid for at the various prices, sell side too. Can you explain what this is? — CarolD4387

Sure, Carol, and don’t worry, I’m sure much has changed since you took your trading classes. Going way back to the 1990s, the NASDAQ market makers were the only ones who had access to what is called Level 2 or depth of book quotations. In the 2000s, everyone was given access, and the games that were/are played now came into being. Putting in false bid or offers to bolster what direction we would like to see the stock move is illegal and should not be done.

The addition of the National Market System (NMS) in 2007, where all orders must be routed to the best possible marketplace, made the depth of book even more meaningless. Add to this the unseen “dark pools” of liquidity and subpenny pricing — and well, you get the idea. Don’t waste money on any of these “special services.”

Originally published in the December 2012 issue of Technical Analysis of Stocks & Commodities magazine. All rights reserved. © Copyright 2012, Technical Analysis, Inc.

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