The Alternatives to Event Trading

By: Peter McKenna

The following is an excerpt from Peter McKenna's The Event-Trading Phenomenon

It would not be proper to advocate a strategy of trading only when events move the market without discussing the alternatives.  I’d like to discuss the alternatives to event trading and demonstrate why they will likely not generate great profits for traders in coming years.  If you do not trade events, you have the following alternatives.

Identify Good Stocks and Sell Them

Identify good stocks and sell them when a profit is made.  To find a good stock among the 9,000 publicly traded stocks you need a good screening system.  There are dozens of systems out there for sale.  If you spend a half hour surfing the Internet, you will find amazing claims by people who want to sell you their system for finding good stocks.  Try to avoid them at all costs.

In my experience, there is only one reliable stock-picking system.  It is the CAN SLIM system developed by William J. O’Neil, the founder of Investor’s Business Daily.  O’Neil is a modern day genius.  That opinion is unsolicited.  I have watched O’Neil’s system work for many, many investors.  If you decide against the event-trading system, and prefer to stick with individual stocks, the CAN SLIM system is the only reliable method, in my opinion, of making money.

The system is based on the ability to find the best companies and to buy their stocks at the best times.  Here are the steps you have to learn to use the CAN SLIM method:

  1. Learn to find stocks with the strongest long-term earnings growth.
  2. Learn to find stocks with the strongest sales, profit margins, relative strength and return-on-equity.
  3. Learn to find companies that are the strongest in their particular market sector.
  4. Learn to use charts to find patterns suggesting that a stock with the characteristics above are about to break out of a basing period and move upward.  You must also acquire the discipline to sell if a stock turns against you by 8% of the purchase price and you must sell when the stock generates a profit of 8% above the purchase price.

This is the best stock-picking system there is.  Investor’s Business Daily clearly identifies for its readers the stocks that fit the qualifications above.  The system works because it centers on the real factors that drive stocks upward, not on the quirky systems developed by people with a far less sophisticated understanding of the stock market, or on Wall Street hype.

This method works best when the market is making large upward gains.  It does not include a method for making money when the market falls.  It also does not provide the leverage of the index options used by event-traders.  Three of four stocks decline when the market drops sharply.  This means even the best stocks, like those you can find using the CAN SLIM system, will drop as well.  In my opinion, the event-trading strategy involves less risk.  But, if you decide to trade stocks, CAN SLIM is the best system available.

Day Trading

When the tech bubble burst, day trading blew up with it.  Day trading evolved from a hobby into a small industry during the bull market.  There were an estimated 3,000 full time day traders in 1999.  According to securities regulations, you are a day trader if you get in and out of the same position on the same day four out of five days.  You must maintain a margin account with a balance of $25,000 to day trade.

There are now even less day traders.  About seven million people invested frequently online during the bull market, but were not day traders.  About five million trade frequently from home or work, using brokerage Internet sites.  By comparison, about 80 million individuals each year buy and hold stocks for the long term.

Day traders try to make money by executing many trades per day, taking small profits, often as small as one fourth or one eighth of a profit per trade.  They have been greatly helped in this endeavor over the years by computer access to what’s called ‘Level Two’ screens.  This enables a trader to see, in real-time, the best bid and offer prices on a particular stock.  In 1999, day traders accounted for about 15% of the Nasdaq’s daily trading volume.

Precise facts and figures on day trading are hard to come by.  Most day trading firms have consistently refused to provide detailed information about the rate of success or failure their traders’ experience.  The Securities and Exchange Commission (SEC) released a report on day trading in 2001.  Among the commission’s findings were the following:

More than half of the traders studied were between 20 and 39 years of age.  More than half of them earned more than $100,000 annually.  The SEC did not say how much of this income came from outside sources and how much came from day trading.

Nearly 80% of the day traders said their net worth was greater than $200,000.  Six percent reported a net worth of less than $50,000.  Therefore, most day traders appear to be under the age of 40, earn more than $100,000 per year, and have a net worth of greater than $200,000.

Day trading involves significant costs.  An introductory course in day trading can cost $5,000.  Trading commissions range from $15 - $25 per trade.  Traders also pay substantial amounts for real-time data feeds and high-speed computer equipment.

A day trader who makes 50 trades per day at a firm with moderate fees must earn $16,850 per month in trading profits just to cover the costs of the trades.

Many day trading firms require customers to make initial deposits ranging from $20,000 to $75,000.  This requirement is sometimes relaxed, depending on the experience of the prospective day trader.

How many day traders are making money, and how many are losing money?  Again, solid information is scare, but anecdotal information indicates that few are doing well.

Day traders must learn an endless number of chart and candlestick patterns.  They must undergo a lengthy and expensive learning process.  During the day they must remain glued to their computers, something many people cannot do.  Event trading is a much simpler way to make money.

Mutual Funds

Mutual funds were designed for investors who couldn’t afford to open a brokerage account, buy stocks and pay high brokerage fees.  It gave them access to stocks, bonds and money market securities they could not otherwise afford.  There are more than 8,300 mutual funds of differing types and investment strategies to choose from.

The concept behind mutual funds is sound.  Let a professional stock picker do the research and buy stocks for you.  It’s a great idea.  The best part of a mutual fund is the power of compounding, which Albert Einstein described as the eighth wonder of the world.  If you put it away and let it grow, your money will grow exponentially.  If the fund returns and average of 10% per year, a $10,000 investment will compound to $1,170,000 in 50 years.

I hope that you noticed that it takes 50 years to make this kind of money, and that’s in a market returning an average of 10% per year.  The average domestic stock fund was down 21% in 2003.  Tech funds, the golden boys of the bull market, were so far down that investors were fleeing in record numbers.

The average tech fund was down 39% in 2001, and 45% in 2003.  To return an average 10% annual rate of return, these funds would have to return more than 80% per year for the next three years.  This is not likely to happen.

Mutual funds were a raging success.  In 1980, total fund assets were $95 billion.  By 2001, total assets had reach $6.8 trillion.  During the bull market, many tech funds had triple-digit returns, a truly remarkable performance.  Investors who piled these funds made small fortunes.  But then the bottom fell out of the market, and fund returns.  Because fund investors had been conditioned to hold for the long term, few of them took profits during the bull market.  This meant they had to start over.  Their funds went from extremely high levels of annual returns to negative returns.  That meant that fund investors had to wait, perhaps decades, to get back their initial investments and then move forward.

Buy and Hold

If you repeat something often enough, it becomes accepted as a fact.  For years, brokerages and certified financial planners have been telling investors to buy stocks and hold on no matter what happens.  This philosophy has been so heavily marketed that it has become a measure of our self-worth.  Those who embrace the idea are wise and mature.  They have the strength of character to deny themselves immediate gratification in favor of the long-term good.  Those who reject the idea are risk takers, with little regard for themselves or their families.  Some investors actually believe their character is flawed if they break out of the buy and hold state of mind.

The acceptance of the buy and hold strategy is understandable.  It frees people from having to think too much about their investment.  It encourages people to relax and put off worrying about their portfolios for years.  This is comforting to most people.  Better days are coming, so all you have to do is let the future unfold.  This is tempting, but dangerous.  You can wake up one morning and find your investment worth next to nothing, as tragically has happened to many people.  One of the many benefits of event trading is that it frees you from this dangerous temptation.  You have to disregard the buy and hold philosophy and take charge of your investments.