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ECN’s and Online, Day and Active Trading

By: , dated January 25th, 2013

ECNs

If the thought of your broker making money off the bid/ask spread makes you less than thrilled, you should be aware that there are alternatives for trading, such as Electronic Communications Networks (ECNs). Electronic Communications Networks (ECNs) represent orders in Nasdaq stocks; they internally match buy and sell orders or represent the highest bid prices and lowest ask prices on the open market. The benefits you get from trading with an ECN include after-hours trading, avoiding market makers (and their spreads), and anonymity (which is often important for large trades).

Online Trading

You might also want to try trading online. Although trading online does not eliminate the role of market makers and specialists, it can provide you with many other conveniences, such as the ability to trade from your desk at work or at home. You should be aware, however, that online trading is not instantaneous, so you still might find yourself wanting to use limit orders instead of market orders. If there is a computer glitch and you are not sure that the order went through, try to contact your broker or issue a cancellation before re-submitting the order. You don’t want to end up owning twice as much stock as you had originally planned on buying.

After Hours

The stock markets in New York have traditionally been open for trading from 9:30 am until 4 pm EST, every Monday through Friday (with the exception of certain holidays). As interest in the stock market has grown, however, there has been greater and greater demand for additional trading hours after the markets close. The markets actually do allow trading after the closing bell — it is known as “after hours” trading. For many years after hours trading was limited to individuals with a high net worth and to institutional investors such as pension funds, but it is becoming more common nowadays as systems like electronic communications networks (ECNs) make it easier for individual investors to access the after-hours market . Before you decide to trade shares after hours, however, you should be aware that trading stocks after hours can be a much different experience than trading during normal hours. For one thing, volume after hours is extremely low, since most investors do not trade after 4 pm. Low volume can lead to high volatility and large bid/ask spreads, and often times there are larger than normal price fluctuations in after hours trading. Until after hours trading becomes more common, it is probably something that should be left for more experienced investors.

Day Trading

Day traders are individuals who are trying to make a career out of buying and selling stocks very quickly, often making dozens of trades in a single day and generally closing all positions at the end of each day.

Day trading can be costly given the impact of commissions and the bid/ask spread. Day traders will typically select a discount broker in order to mitigate the cost of commissions on overall profits. Here are some tips for day trading:

  • Avoid the red-hot stocks and the household names. This is where the day trading pros tend to hang out, so you’ll be competing with the best traders if you focus on these stocks.
  • Find stocks linked to indicators and trade based on movements in those indicators. For example: bank stocks do well when interest rates fall; transportation stocks do well when oil prices fall; export-oriented companies do well and import-oriented companies do poorly when the dollar is weak. If you spot a stock which should be moving due to an indicator but isn’t, it could be a buying/selling opportunity.
  • Sell in the first hour of the day and buy in the last hour of the day. Day traders and market makers often close out some of their positions at the end of the day. This results in buying pressure in the morning and selling pressure in the afternoon, which you may be able to capitalize on. However, this strategy may no longer work with the advent of around-the-clock trading.
  • Don’t overtrade. You’ll be paddling upstream with each commission, so don’t be afraid to just sit at your computer and do nothing. Don’t chase after bad trades because you feel like you’re wasting your time.
  • Set a limit to how much you’re willing to lose and if you lose that much then get out.
  • Learn more. The tips above aren’t nearly enough to make you a successful day trader. There are a large number of books on the subject, and you’ll want to do a lot of learning before putting any of your hard-earned money at risk.

Active Trading

Active traders buy and sell stocks frequently but haven’t pursued it as a full time job. Unlike day traders, active traders trade once or twice a day, and don’t close out all their positions at the end of the day. While a day trader might only hold a given position for a few minutes, active traders often hold onto their stocks for days, weeks or even months. Also, while a day trader generally pays a large fee to their firm to use special trading software as well as a commission, an active trader usually sticks with a deep discount online broker or Level II Nasdaq quotes.

A few more tips about active trading:

  • You may be able to deduct some of the expenses incurred in the process of trading (provided they exceed 2% of your AGI), including margin interest, real-time quote costs, investment research costs, software costs, and internet access costs associated with investing. If you do this, keep accurate records.
  • There is an IRS regulation called the Wash Sale Rule, regarding selling a security at a loss and then buying back the same security or a very similar one within 30 days. When a wash sale occurs, you can’t deduct the losses for tax purposes, but instead must add the disallowed loss to the cost of the new security. This postpones the loss deduction until the new security is sold. This is an unfortunate but unavoidable problem that active traders must deal with but that buy-and-hold investors don’t have to worry about.
This article was brought to you by the InvestorGuide Staff Writers and Editors.

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