This is the followup to my previous post IRS Declares me one of the top Day Traders in History

In that post, I tell about my (futile) discussion with the IRS where they claim that I made a profit of over $2,500,000 on a $30,000 account.  At the time I had no clue how the IRS got such an idea, but after doing some research I understand how it happened.

Evidently there are tax 2 forms that your stockbroker issues.  The first form itemizes every trade that you made, the profit or loss on each trade, and at the very end the total profit or loss for the year on all the trades.  You might assume this very long form would pretty much provide what you need to pay your taxes, but they produce a second form also.  The second form is very short and contains basically one number, which is the sum of cost of the securities of every trade you made.  For example suppose you bought 500 shares of a stock at 42.80 per share, that's $21,400.  Then you sold all 500 shares at a small loss for 42.10 per share, that's $21,050.  So for your first round trip that's over $42,000.  Now suppose this is is an average size trade for you and make 200 trades for the year, then the number on the form would be over $8,400,000.  Impressive for bragging rights, but having absolutely nothing to do with how much money you made (or lost).

Now here's the punchline.  I surmisedthat in my case the IRS had gotten the second form from my broker, but NOT the first.  So I sent them that form.

As the weeks went by I was fully expecting a personal letter from the IRS thanking me for my cooperation and complimenting me for being such fine American.  To my surprise I received a form letter instructing me to send them $112 in back taxes, plus $9 interest.

        

Just in case you question the value of my advice, you should be aware that the IRS has declared my one of the top Day Traders in history.  You might question my veracity, but how can you question the veracity of the IRS?

OK, so maybe the IRS didn't say it in those exact words...

It all started a few weeks back when I received an official letter from the IRS. There was a discrepancy in tax year 2006 between what I had reported to the IRS and what the IRS says my stockbroker reported (regarding my Day Trading account).  I don't recall exactly what I reported, but it was a small loss.  But the IRS claims that my broker reported that I made a profit of over $2,500,000.  Yes, over 2.5 million dollars.  Please realize that my trading account was less than $30,000. So I must be one of the top Day Traders in history.  Do the math: that's an 8333% return!

OK, so I'm not one of the top Day Traders in history. Obviously the IRS has made a mistake.

I notice on the letter there's a telephone number to call the IRS if you have any questions.  So I figure I'll call the number and see if I can get them to straighten this out.  I dial the number and an extremely friendly person answers immediately. I can't believe the IRS picks up their phone so quickly!  Unfortunately I soon realize I'm talking to a trucking company - evidently I've dialed the wrong number. I dial again, and after about an hour of pressing keys and holding, I'm actually speaking to a human being.  I explain the situation to her, saying it's an obvious mistake, and can she please correct it.  About five minutes into the conversation I realize I've entered a strange world of unreality.  It makes absolutely no difference how absurd it sounds, their information states that I made $2,500,000 and they refuse to correct it.  If my file said I made three times the Gross National Product of of the United States, they would still refuse to correct it.   It is up to me to provide acceptable documentation proving that I did NOT make $2,500,000, or else pay the taxes on it. 

I hang up. and then it occurs to me I would have gotten more satisfaction talking to the trucking company.

Gotta go now, need to call my accountant.

Wanna know how this turns out?  Check back soon, I'll post as the story unfolds. Does anyone know if you can blog from prison?

        

In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 7:

Get a good trading computer and Internet connection

As a Day Trader you depend on your computer to execute trades and analyze charts.  So you need a computer that can do these things quickly and reliably.  And you need a high speed Internet connection that doesn't often go down.

Meet these requirements and you will be OK.  A crappy computer or Internet connect will cause you aggravation and even cause you to lose money trading.  On the other hand, past a certain point, spending more money on a computer will not make you a better trader.

This post will not give you all the info you need to choose a good trading PC, but here are few guidelines.

Get a decent processor.  Look for at least dual core, at least 2 GHz.

Get enough RAM.  Get at least 2 GB.  Many decent PC's come with 1 GB standard, my advice is to shell out the extra bucks to upgrade to 2 GB. 

Hard drive space is less essential than RAM, but given it's cheap look to get 500 GB or more.

Most traders like a lot of monitor space.  I would recommend at least two 19" monitors, three is even better.  Be aware that 3 monitors adds quite a bit of setup complexity and expense.  You can't just buy your standard off the shelf PC and attach 3 monitors to it. But IMHO 3 monitors is really the way to go.

If you are purchasing a PC and you're not a "techie", it's a good idea to purchase from a company that will help you choose the right PC and get is built and configured for you.  Call up a few retailers and speak to their tech support people about your purchase requirements.  Remember good support can be really valuable.

        

In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 6:

Determine how much money you will need to fund your trading account

"What is the minimum height to become a basketball player in the NBA?" the coach was asked.  "There is no minimum height" was his reply "But if you're under 6 feet you pretty much have no chance".

"What is the minimum amount of cash I will need to get started in Day Trading?" you ask.  There is no minimum amount, but if you start with less than my recommendations in this post you pretty much have no chance.  And as in basketball, having just the minimum can put you at a disadvantage.

Luckily, if you are an American citizen and you wish to trade stocks, the SEC has been kind enough to give you a definitive answer. And that answer is $25,000.  Let me explain.  The SEC has specific rules regarding what they call a Pattern Day Trader.  Anyone who Day Trades will be labeled as a "Pattern Day Trader" very quickly (I wear the label proudly). And the SEC requires "Pattern Day Traders" to have a minimum account size of $25,000.

With this in mind you open a brokerage account with $25,000. You make a half dozen trades, and after commissions, your account value dips to $24,951.  You try to place another trade, but the trade simply won't execute.  No, there's nothing wrong with your trading platform - your broker is just enforcing the SEC rules.  Your feeling of annoyance is misplaced - you should really be thanking your broker for going out of his way to support the SEC.  So a more practical minimum account size for stock trading would be somewhere around $30,000.

Hey guess what?  Just when you thought the SEC was close to perfect, I'm here to tell you they forgot something.   They forgot about futures traders.  If you trade futures (including e-mini futures) there is no minimum account size set by the SEC or any other agency of your friendly Uncle Sam.  You are only limited by broker minimum account sizes, margins and common sense.  Some brokers have a minimum account size of $10,000 and some are less.  

In case  you are not familiar with e-minis let me explain what I just said about margins above.  When you trade e-minis you buy (or sell) a contract, as opposed to a share in stock trading.  A small trader of e-minis might buy 1 or 2 contacts, in the same same way that a small trader of stocks might buy 100 or 200 shares.  The e-mini margin requirement is the amount that your broker requires you to have in your account per contract you trade.  Depending on who your broker is, and which e-mini you are trading, the margin requirement would be somewhere in the area of $2000 to $5000 per contract.  Add a little common sense to the broker account minimums and the margin requirements, so a ballpark minimum amount of cash you need to get started in trading e-minis is $15,000.  

Please note that you need this much that you can actually put into your trading account.  This does not include other trading expenses, like a decent computer or monthly data feed expenses.  But more importantly you must consider that the money put in your trading account must be money you are willing to put at risk.  Your available cash should be much more that the amount you use to fund you account. How much more in not for me to say.

A  friend of a friend of mine once asked my advice.  He said "I have about $6000 total cash.  I hope to raise another few thousand by selling my car, and a few thousand more on a credit card cash advance.  This should give me about $12,000 to open a Trading account.  Can you recommend a good broker?"  My response was "No, but I can recommend a good psychotherapist".

        

In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 5:

Create Risk Management Rules

Suppose you had a specially weighted coin that when flipped came up heads 55% of the time and tails 45% of the time.  You have a pot of $30,000 to wager on coin flips.   You can choose to bet as much or as little as you want on each flip.  The amount you wager is added to your pot if you correctly call the flip, or subtracted from your pot if you're wrong.  You can go on forever as long as you still have money in your pot.  Obviously you want to increase your pot as much as possible. Seems hard to lose with a weighted coin!

Now the game begins.  You wager $1000, and call heads (of course).  The coin lands on heads, you win, so you now have $31,000.   You wager $1000 again, call heads, coin lands on heads again, so you now have $32,000. Things are going your way, so next you wager $12000.  This time you lose, so you're down to $20,000.  No problem, you know the odds are in your favor, so you wager $12000 again.  Again you lose, so you are down to $8000.  This upsets you a bit, but you figure with a weighted coin there no way there could be 3 tails in a row.  So you wager the remaining $8000.  Unbelievably, you lose again, & you have nothing left.  Game over!

You sit there stunned, pondering how it is possible that you lost $30,000 when the odds were clearly in your favor.  The answer, of course, is that you used poor money management.  Favorable odds will play out over the long term, but not necessarily over the short term.  In order to let the odds play out, you have to risk a smaller percentage of your total pot. 

This coin flipping game is analogous to trading.  You start out with a fixed amount of cash in your trading account, and each trade is like a coin flip. 

Now suppose you have a $30,000 trading account.  You decide to buy 500 shares of a stock that's selling for $40/ share: that would cost $20,000.  Obviously $20,000 is too much to risk $30,000 trading account - this is why you should use a STOP LOSS.  So when you buy the stock, you instruct your broker to immediately sell if the stock goes to $39.  Thus you limit your risk to $500.  

The STOP LOSS is the basic building block of any Risk Mangement plan.  There can be much discussion as to what size to set your STOP LOSS, but there should be no discussion as to whether or not you should use a STOP LOSS.  Use a STOP LOSS or eventually you will wipe out your account.  Period. 

So here's your first Risk Management Rule.  Always use a STOP LOSS with every trade

A simple Risk Management plan consists of just 4 more Rules:

1. Maximum % of your account value you will lose per trade (determined by your STOP LOSS)
2. Maximum % of your account value you will lose per day
3. Maximum % of your account value you will lose per week
4. Maximum % of your account value you will lose per month

Here is an example of the Risk Management Rules:

1. Maximum I will lose per trade is 1% of my account
2. Maximum I will lose per day is 3% of my account
3. Maximum I will lose per week is 7% of my account
4. Maximum I will lose per month is 10% of my account

The % numbers I use above are only meant to be an example.  You will need to decide on the exact numbers you want to use.  Setting a good STOP LOSS for a particular stock or commodity is something of an art: a "tight" stop loss reduces risk per trade but can lead to getting stopped out too often. 

To illustrate the sample rules above, suppose you have a $30,000 trading account. Per Rule #1, the max you can lose per trade is 1%, or $300.  So you could buy 300 shares of a stock selling for $40/share, and set your STOP at $39.  Or you could buy 100 shares at $40/share and set your STOP at $37. Per Rule #2, the max you can lose per day is 3%, or $900. Once you have lost $900, you MUST have the discipline to quit trading for the rest of the day.  Now suppose you have lost $750 so far today - can you make a trade risking $300? NO!  Because if the trade went against you, you would exceed your $900 daily max loss.  Per Rule #3, the max you can lose per week is 7%, or $2100.  If you've lost this much and it's only Wednesday, you MUST have the discipline to quit trading for the rest of the week.  Per Rule #4, the max you can lose per month is 10%, or $3000 - you get the idea.

Create your own Risk Management Rules before you make even one trade. 

If you don't have the discipline to follow your Risk Management Rules, you may wish to purchase my "Bash-O-Matic Traders Helper".  This highly sophisicated, programable, electromechanical device is compatible with most PC's and mounts conveniently on your desk.  Once installed, a large hammer automatically hits the trader over the head as soon as it senses any Risk Management Rule has been violated.  To order yours, simply send $9999.99 cash to:  

Miracletech LLC
PO Box 123
Cayman Islands

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In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 4:

Understand the importance of Discipline and Trader Psychology

Self-Discipline means doing all the things that you need to do be a good Trader, even when you don't feel like doing them.  As a Trader you will need greater self-discipline than as a employee.  As an employee much of the discipline necessary to do your job comes from the outside, from your boss, company rules, etc.  As a self-employed trader, all your discipline must come from within.  Plus any lack of self-disipline is likely to be more serious for the trader than the employee, as the employee is usually just one part of a larger whole.

The thing to realize about self-discipline is that it can go a long way, but it can only go so far.  That's why you really have to love trading, & be fascinated by the markets, in order to be successful.  It's just very difficult to motivate yourself to do something day after day if you don't like it.  So if you're thinking about trading just for the money, but it doesn't really turn you on, forget it now because you'll never be able to find the self-discipline necessary to be successful.  This is probably true of any field, but trading is much less "forgiving" than most.

I suggest you read this Self-Discipline article by Steve Pavlina.  It is not specific to Trading but definitely is worth while.

How will you develope expertise as a Trader?  How will you find your specific trading niche?  These are questions of Trader Psychology.  To learn about this I suggest you read Enhancing Trader Performance by Brett Steenbarger.  This is is best book I know of on the subject. 

The other part of Trader Psychology you need to be aware of is the tendency of human beings to make irrational Trading decisions.  This is not just a lack of education or experience, but there seems to be evidence the problem is actually be built into the human brain.  Read a good explanation of this in Dr Dorn's "Your Rat Brain Is Out To Get You"

Kahneman and Tversky's paper on Prospect Theory won them a Nobel Prize in Economics.  This is not what I would call light reading, but essentially they prove empirically that people act irrationally when faced with decisions involving Risk.  If you think even casually about what Day Traders do, it's constantly making decision after decision on Risk.  After all, placing a trade is just making a decision on risk, whether you think of it that way or not.

OK, so at least you want to trade as unemotionally as possible, right?  Not necessarily.  There's a lot of evidence emotions are necessary in good decision making.  Blink by Malcolm Gladwell is a good book on the subject (not specific to trading).

The point of this post is to make you aware of the some of the issues regarding Discipline and Trader Psychology, and stress their importance.  But even if you read everything is this post's links, you will just be scratching the surface of the understanding of these topics you'll need to be a successful Tuff Trader

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In my post Day Trading Lesson: The Roadmap I present a list of steps to learn to Day Trade.  Here are the details of Step 3:

Learn the basic terms & concepts related to Day Trading

If you are a newbie, of course you need to know the basic terms and concepts before you can go much further.  IMHO Investopedia does a great job of explaining these basics, thus the many links to them below. Just try to ignore all the annoying ads.

There are  two conceptually different methods (schools of thought) for making trading decisions that you must understand  i.e,  Technical Analyses vs. Fundamental Analyses.  As a Day Trader I largely ignore Fundamental Analyses.   Technical Analyses mostly involves making trading decisions based on Chart patterns or indicators.  There are probably hundreds of technical indicators.  As a beginner you should become familiar with as many as possible, but it's only necessary to truely master just a few to become a profitable Day Trader.

Next understand the difference between Long and Short.  When you enter a trade, you either take a Long Position or Short Position.  When you go Long you hope the price will increase so you will make a profit. When you go Short you hope the price will decrease so you will make a profit.  It's that simple - that's all Day Traders really do.  Your technical analyses tells you the price of an instrument (Stock, Future, e-mini or whatever)is about to go up, so you enter the trade Long - if you are correct you make a profit.  Or, technical analyses tells you the price of the instrument is about to go down, so you enter the trade Short - if you are correct you make a profit.  This is the basic concept, but in practice Short Selling of stocks presents a few additional complications you'll need to understand (if you chose to trade stocks) as you are actually borrowing the stock from your broker - these complications do not exist with Futures.

You can trade either Futures (which include E-Minis) or Stocks (or Forex, which I do not discuss in this Blog).  They are quite different in many ways, but from a Day Trader's point of view they are very much the same in one aspect: You can use the same Chart patterns and Indicators to make trading decisions with Stocks or Futures.  Depending what the Chart shows you either go Long or you go Short. 

One big difference between Stocks and Futures is Leverage.  Futures are more highly leveraged.  That means for a given amount of money risked on a Futures contract, you stand to make (or lose) more money for a given percentage of movement than if you had put that same amount of money in a stock. 

Ok, so you know that whatever instrument you are trading in can either go Long or go Short.  But of course there is one more choice, which it simply to stand aside (ie stay out of the market).  This may seem too obvious to mention, but it is the very essence of successful Day Trading.  Failure to "Get" this point will cause even experienced Traders to lose money. A good trader spends most of his day waiting, not trading.  There a some moments during the day when the statistical odds are that the stock will drop, so the good Trader goes Short.  There a some moments during the day when the statistical odds are that the stock will rise, so the good Trader goes Long.  But there are many moments during the day when the statistical odds point to no particular direction, so the good trader stands aside, and the Schmucks trade.

Next you should understand something about the nature of Electronic Trading.

Other important terms are:

Volume

Bid, Ask and  Bid-Ask Spread

Slippage

CandleStick

Index

Market Order vs Limit Order

Tick

So, did I cover all the terms and concepts you need to know to Day Trade?  Of course not!  But hopefully it's at least a small start.  You can look up terms you don't know as you come across them.


 

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In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 2:

Start a Traders Diary

This is simple in concept but extremely valuable.  Essentially all you do write a daily entry on all your trading activities.  Your diary software can be as simply a Word Document, or any software you want to use is OK.  You can even write it in a paper notebook if you like.  Just type is today's date and whatever you did today in your trading or your trading education. 

The purpose of the diary is to allow you to periodically look back at it and gauge your progress as a trader.  Keep this in mind as a guide as to what you should include in your daily entries.  You should include concrete things like "today I spend 2.5 hrs analyzing the 5 period moving average of the YM e-mini over the past 7 trading sessions".  But you should also include your feelings like "today I got really frustrated when I was trying to ...  So I took a 30 minute break & when I got back I felt a little better"

It's OK that everyone will do their Diary differently, as a reflection of their own personality.  But I strongly suggest you follow 2 RULES:

1. Write an entry every single day. Even if on a particular day you did not work on trading, write a quick diary entry to say so - this is valuable info too.  One reason you must write every day is because it's too easy to gradually forget about doing the diary.  If you make up your mind that you will do it every day, it's more likely you can keep doing it forever.  Suppose you make up your mind that you will do it every day, and after a week or so you just forget about it?  This may be a clue that you don't really have the discipline necessary to be a successful Day Trader.

2. Periodically review your entries.  For example, you could every Sunday review your entries for the past week, and the 1st of every month review your entries for the past month.  The idea is to judge your progress as a trader - to gain perspective.  Ask yourself questions like:  Am I consistently making progress? Am I putting in enought time?  What mistakes have I made?  If I continue to do what I have been doing, am I likely to meet my goal for trading cash profitably?

You have probably heard the saying "The definition of insanity is doing the same thing over and over and expecting different results".  Think of your diary as illumination tool to help you avoid this sort of insanity.



 
 

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In my post Day Trading Lesson: The Roadmap I present to list of steps to learn to Day Trade.  Here are the details of Step 1:

Decide if Day Trading is really for you

This is not a trivial decision.  Because Day Trading is NOT for everyone!  Here are some of the reasons folks want to Day Trade:

• Be your own boss
• It sounds cool!
• Make money based on your actual skill and efforts, as opposed to someone else's opinion of your skills and efforts
• No credentials are necessary
• Set you own hours (only somewhat true)
• Work from home - no commute - no dress code
• Avoid all the crap of working for Corporate America

But you need to fully accept these realities before you decide Day Trading is really for you:

• It's going to take a long time to learn and its going to take a lot of effort
• There is risk involved.  Yes, you can lose money!  In fact you definitely will have losing trades.  Let me repeat that: you will have losing trades! Probably daily. Taking loses is just part of the game.  Not everyone has the personality to live with this.  In fact, you may not even know if you can live with it until you've taken a few losses.
• You will spend a long time each day indoors staring at a computer screen. And you will mostly be working alone.  Not for everyone
• You need to be self disciplined.  A lot a folks will just skip over this one, because their ego tells them "of course I'm self disciplined" - don't make this mistake - this is a key element of trading and not everyone has it.  If you have been working a regular 9 - 5 job there is a lot of discipline imposed on you from the outside that you may not even be aware of.  As a day Trader you and you alone are responsible  for every single action you take (or fail to take).  And you need to have the discipline to say no to your "Rat Brain".  You can read about the "Rat Brain" here but suffice to say it will try to get you to make irrational trades.  Again, you may not even know if you have the necessary discipline until you've been trading a while
• You will need a sizable amount of money to fund your Trading account.  A future post will help you determine how much you'll need, but right now let's just say $15,000 is a realistic minimum.  This does not include purchasing a decent computer if you don't already have one
• You need the creativity to develope your own unique trading method.  You will not be successful if you take someone else's method and simply try to repeat exactly what they do.  Even if you were lucky enough to find a successful trader who was honestly willing to try to share with you everything they knew. The best you can do is take someone elses general method, and modify it to be your own.
• There is a high rate of failure among those those trying to Day Trade.  Let's not sugar coat it - failure usually means losing a lot of money then throwing in the towel.   I created the Roadmap in the hope of reducing the rate of failure among those newbies willing to follow it.

 

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In my debut (debatable) post It’s harder to become a Day Trader than a Surgeon I make the point it’s so difficult to become a Day Trader because newbies lack a path or roadmap – a list of specific steps to follow to become a successful Day Trader. So I created this roadmap.  There is no such thing a the one definitive roadmap - just as on a real roadmap there can be different paths to the same destination.  That said, here’s a pretty good roadmap based on me spending way too much time on Trading and research:  

1.  Decide if Day Trading is really for you
2.  Start a Traders Diary
3.  Learn the basic terms and concepts related to Day Trading
4.  Understand the importance of Discipline and Trader Psychology
5.  Create Risk Management Rules
6.  Determine how much money you will need to fund your trading acct 
7.  Get a good trading computer and Internet connection
8.  Get a good Broker, Charting Package, Data Feed and Trading Front End
9.  Decide What to Trade (Stocks, Futures, or Forex)
10.  Define your Trading Edge
11.  Prove your Edge by Taking Stats on Historical Charts
12.  Create a Trading Plan
13.  Sim-Trade profitably
14.  Trade Cash

Follow this Roadmap and by the end you will be a TuffTrader, and maybe make a little money.  Future posts will elaborate on each step in detail.  WOW!  There's a lot of hard work ahead.  If you find it fun, then just maybe you have what it takes.

Thinking of ignoring steps 1 - 13 and going straight to step 14?  Then you didn’t get the message in my post Accept it's going to take a long time to Learn

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