We have noticed that a lot beginning traders gravitate towards trading the indexes (S&P500, DJIA, etc.) using ETFs, Futures, or options. But many people may have an easier time making money trading stocks. It is impossible to prove this, but our impression from spending hundreds of hours browsing forums and books on trading is that the traders who have a lot of success quickly tend to trade individual stocks.
There are many advantages to trading financial instruments based on big indexes because those have the best volume and liquidity. Also, it is easier to find liquid leveraged instruments to trade indexes as opposed to stocks. However, there are some important advantages to trading stocks.
Good traders can make money whether the market is in an uptrend, a range, or a strong downtrend. But if you are a beginning trader, which of these markets would you rather be trading:
I think most people would look at these charts and choose the 2nd one that is in a clear uptrend. When you look at the other charts is it clear whether you want to be long or short? I think it’s unclear, and you would need more information to get a better sense of whether the markets are more likely to continue down or reverse.
The problem with trading the S&P 500 is that sometimes it is in a strong uptrend, but a lot of time it is in a trading range on many timeframes, or small trends in a larger range. If you like to trade strong trends then much of the time the market is not cooperating with you, and your setups that work well in strong trends are not going to work as well (if at all) in range-bound markets.
But you can almost always find individual stocks that are in strong trends, and you can almost always find stocks that are in trading ranges. Whatever market condition you like to trade in, you can probably find multiple stocks in your preferred type of market. And that means it is easier to trade the same pattern over and over and have consistent results.
For example, many people like to buy pullbacks in strong trends. They have some criteria defining what kind of pullbacks are ‘good’ setups and they scan for stocks with those setups. But the win rate on those trades is going to vary based on the larger time frame market condition. If you trade trading that setup on the S&P 500 futures you may go through periods when it works well and other periods where it doesn’t. Inevitably, trading systems will go through losing streaks just because of bad luck. But often losing streaks are caused because the market changed what it was doing on some higher time frame and so setups that seem to be the same pattern actually performs much differently than it did when the market was in a strong trend.
Another disadvantage of trading the indices is that those markets attract the best traders in the world and the big banks and hedge funds because those large traders need to trade in markets with a lot of volume so they can buy and sell large positions without causing large gyrations in the price. It’s hard to prove, but many traders will tell you they think the edges in those markets are smaller because they are more efficient, and there are bigger edges is smaller markets that don’t have so many sharks swimming around.
But if you trade markets that are too small, with very low liquidity, you will quickly realize you lose money because of slippage. What is slippage? Slippage is basically money that you lose because of large spreads between the bid and offer and so it’s harder to make trades (especially if you trade large size) at the prices you want.
For example, let’s say you trade SPY (an ETF that tracks the S&P 500) and buy at 270 expecting it to go up to 271 and you have a stop loss set at 269. The spread (difference between bid and offer) on the SPY is usually only $.01. If the price drops through 269 your broker will sell your position with a market order. At that time the bid price may be 268.99 and the offer will be at 269 (so a $.01 spread). When your broker sells with a market order that means they will sell your stock immediately at the best price they can get which is the bid price. So you would exit your position at 268.99.
On the other hand, what if you had a thinly traded stock that you wanted to exit at 269 but the bid was 268 and the offer was 269 (a $1 spread). If you exit with a market order you would be executed at 268 which is a whole dollar less than where you wanted to exit. If you were trading 100 shares that’s an extra $100 you lost because of slippage in a thinly traded market.
So when you trade stocks you need to do some testing to determine what stocks are liquid enough that you can make money with your strategy. Various sources often suggest only trading stocks with at least 200k – 400k of average daily volume. Our experience is that is a reasonable starting point, but you should still do your own testing.