Hooked on Speed: How Day Trading Works

Day traders don’t care what a company makes or what its earnings may be. They’re concerned only with its stock price and whether it’s moving--either up or down.

Ideally, they dive into a stock, watch it rise as little as one-eighth of a point (13 cents a share), and sell immediately. Small profits, made scores of times each day, can add up to big money if you’re trading enough shares.

The game is all about speed. To make money, day traders must anticipate minor stock moves before they occur and dart in and out at precisely the right moments.

To accomplish this, they rely on trading technology that is still largely unavailable to regular investors:

* First, the special high-powered computers day traders use allow them to view other investors’ and dealers’ offers to buy and sell any stock traded on the electronic Nasdaq Stock Market--a key to gauging the immediate direction of a stock’s price.

These “order flow” data are displayed on so-called Level II screens. If, for example, people seem to be lining up to buy a stock--as shown by rising bids for larger share blocks--that’s a sign to day traders that the price may rise short-term.

* Second, day traders can swap stocks directly with other investors (including other day traders) rather than having to place orders through brokers.

An ordinary online investor buys a stock by sending an electronic order to a broker, who makes the actual purchase and sends back an e-mail disclosing the price paid.

By contrast, a day trader who spies an attractive price can hit a button to execute the order directly with another investor through trading systems known as electronic communication networks, or ECNs.

In the best case, the order is filled. But not always. If, for example, a third trader has sent in a buy order a split second earlier, that person’s order gets filled and the day trader’s order is rejected--and must be submitted anew. In the meantime, the market price may have changed.

The appeal of Level II screens and ECNs is that they in effect let day traders walk through the aisles of an electronic swap meet, quickly snatching up or discarding stocks at favorable prices rather than depending on someone else (a broker) who may not come away with the best deals.

But in practice, identifying the right trade, acting quickly and getting the desired fill can be very difficult.

That is shown most dramatically in the case of Internet stocks.

Scores of day traders have made money in Internet stocks in recent months as the shares’ prices have rocketed. Yet many day traders also have gotten creamed in Internet issues.

“I’ve made every mistake in the book, and the biggest mistake I’ve made was trading Internet stocks,” said day trader Richard V. Rueb.

The problem: Extreme volatility can be not only a day trader’s best friend, but also his nemesis.

“Our best traders get killed on” Internet stocks, said Eyal Shahar, co-owner of the Irvine branch of day-trading firm Momentum Securities. “If you happen to get caught on the wrong side on a run of 20 points of Yahoo with 1,000 shares, it’s 20 grand. If your account size is $40,000, you can lose within 15 minutes 50% of your account equity.”

If Yahoo suddenly tanks, why wouldn’t a day trader simply sell it before racking up enormous losses? The short answer: Because he can’t.

When a volatile Internet stock begins to fall, bids to buy the stock all but vanish. And the bids that remain in the market get “hit” with lightning speed.

For example, if XYZ stock begins to fall from a price of $100, a day trader may put in an order to sell at $99. But if someone else already has sold at $99, the market price may be down to $95 by the time the trader can type a new price on his terminal and push the button. If that pattern repeats just once or twice, the trader can easily lose $10 a share on a stock--or $1,000 per 100-share lot.

Larry Hartman, a day trader at Momentum Securities, recently suffered through exactly that scenario.

He bought Internet search firm Lycos just ahead of an $11-a-share rise. But when the upward run ended and the stock began to fall, Hartman couldn’t find a buyer to take it off his hands.

After frantically pounding the sell button for a minute or so, he finally unloaded it $9.50 a share lower, relieved to have salvaged a $1.50-a-share net gain.