SHORT SELLING AND LEVERAGE
SHORT SELLING AND LEVERAGE
In a certain sense, day trading isn’t risky at all. Day traders close out their positions overnight to minimize the possibility of something going wrong while the trader isn’t paying attention. Each trade is based on finding a small price change in the market over a short period of time, so it’s unlikely that anything is going to change dramatically. But here’s the thing: Trading this way leads to small returns. It’s hard to justify trading full time if you aren’t making a lot of money when you do it, no matter how low your risk is.
And, of course, some days, there aren’t many good trades to make. You can be looking for securities to go up, and they aren’t. Zero trades lead to zero risk, and zero return.
That’s why savvy traders think about other ways to make money on their trades, even if it involves taking on more risk. It’s that risk that generates the return that many traders crave. In this chapter, I cover two techniques for finding trades and increasing returns: short selling and leverage. Both involve borrowing, also known as leverage, and both increase risk.
Taking Other People’s Money to Make Money
The dollars you make from trading depend on two things: your percentage return on your trades and the dollars you have to start out with. If you double your money but only have a $1,000 account, then you are left with $2,000. If you get a 10 percent return but have a $1,000,000 account, then you make $100,000. Which would you rather have? (Yes, I know, you’d rather double your money with the $1,000,000 account. But I didn’t give you that choice, alas.)
The point is that the more money you have to trade, the more dollars you can generate, even if the return on the trade itself is small. If you have $500,000 and borrow $500,000 more, then your 10 percent return will give you $100,000 to take home, not $50,000. You have doubled the dollars returned to you by doubling the money you used to place the trades, not by doubling the performance of the trade itself. Clever, huh?
Leverage gives you more money to trade. That helps you generate more dollars for your account — or lose more dollars, if you aren’t careful or have a string of reversals.
When you borrow money or shares of stock, you have to pay it back, no matter what happens. That’s why borrowing can be risky.
Why leverage is important in short-term trading
Day traders and other short-term traders aren’t looking to make big money on any single trade. Instead, the goal is to make small money on a whole bunch of trades. Unfortunately, it can be hard for all those little trades to add up to something big. That’s why many day traders turn to leverage. They either borrow money or stock from their brokerage firm, or they trade securities that have built-in leverage, such as futures and foreign exchange.
The fine print on margin agreements
Leverage not only adds risk to your own account, it adds risk to the entire financial system. If everyone borrowed money and then some big market catastrophe happened, then no one would be able to repay their loans, and those who lent the money would go bust, too.
As a result, there’s an incredible amount of oversight that goes with leverage strategies. The Securities and Exchange Commission, the Commodity Futures Trading Commission, the different exchanges, and even the U.S. Treasury Department regulate how much money a trader can borrow. Many brokerage firms have even stricter rules in place as part of their risk management, and they are expected to demonstrate to the National Association of Securities Dealers and the National Futures Association that they follow their practices.
This means you have about as much flexibility when you borrow from your broker in order to buy and sell securities as you would have if you borrowed from your friendly neighborhood loan shark to play a high-stakes poker game. Meaning: not much. Margin loans are highly regulated, and you must meet the broker’s terms. If you fail to repay the loan, your positions will be sold from underneath you. If you try to borrow too much, you will be cut off. No amount of begging and pleading will help you.
Your brokerage firm makes you sign a margin agreement, which says that you understand the risks and limits of your activities. You probably can’t have a margin account unless you meet a minimum account size, maybe $10,000 or more, and the amount you can borrow depends on the size of your account. Generally, a stock or bond account must hold 50 percent of the purchase price of securities when you borrow the money. The price of those securities can go down, but if they go down so much that the account now holds only 25 percent of the value of the loan, you’ll get a margin call. (Some brokers will call in loans faster than others; their policies are disclosed in their margin agreements.)
Brokerage firms handle margin trades all the time. You do the paperwork once, when you sign a margin agreement. Each time you place an order, you’re asked if you are making the trade with cash or on margin. Click the “Margin” box, and you’ve just borrowed money. It’s that easy.
Managing margin calls
If the value of your account starts falling, and it looks like it is falling below the 25 percent maintenance margin limit, you’ll get a margin call. Your broker will call you and ask you to deposit more money in your account. If you can’t do that, the broker will start selling your securities to close out the loan. And if you don’t have enough to pay off the loan, the broker will close your account and put a lien, which is a claim on your assets, against you.
Most brokerage firms have risk-management limits in place, so you’ll probably get plenty of warning before you get a margin call or see your account closed out. After all, neither you nor your brokerage firm wants to lose money. Just keep in mind that it’s a possibility.
At least one brokerage firm advertises that, as a service to you, it will close out your account as soon as you lose the amount in it, to keep you from losing more money. It’s as much a service to the brokerage as it is to you, but it’s an example of the built-in risk management that firms have to limit risks to everyone.
Margin bargains for day traders only
Day traders are often able to avoid margin calls because they borrow money for such short periods of time. Good day traders look for small market moves and cut their losses early on, which minimizes the risk of using other people’s money. And, by definition, day traders close out their positions every night.
If you qualify as a pattern day trader, you get two benefits. First, your brokerage firm probably won’t charge you any interest as long as you do not hold a margin loan balance overnight. Second, you may be allowed to borrow more than 50 percent of the purchase price of securities. Some firms allow pattern day traders to borrow 75 percent or more of their trade value.
The New York Stock Exchange and National Association of Securities Dealers define a pattern day trader as one with a margin account holding at least $25,000. This trader must also buy then sell, or sell short then buy, the same security on the same day four or more times in five business days. The number of day trades should be more than six percent of the customer’s total trading activity for that same five-day period.
Traditionally, investors and traders want to buy low and sell high. They buy a position in a security and then wait for the price to go up. It’s not a bad way to make money, especially because if the country’s economy continues to grow even a little bit, then businesses are going to grow and so are their stocks.
But even in a good economy, some securities go down. The company may be mismanaged, it may sell a product that’s out of favor, or maybe it’s just having a string of bad days. For that matter, maybe it went up a little too much in price, and now investors are coming to their senses. In these situations, you can’t make money buying low and selling high. If only there were a way to reverse the situation.
Well, there is a way — selling short. And in short — hah! — selling short means that you borrow a security and then sell it in hopes of repaying the loan of the shares by buying back cheaper shares later on.
In trading lingo, when you own something, you are considered to be long. When you sell it, you are considered to be short. You don’t have to be long before you go short.
How to sell short
Most brokerage firms make it easy to sell short. You simply place an order to sell the stock, and the broker asks whether you are selling shares that you own or selling short. Once you place the order, the brokerage firm goes about borrowing shares for you to sell. It loans the shares to your account and executes the sell order.
You can’t sell short unless the brokerage firm is able to borrow the shares. Sometimes, so many people have sold a stock short that there are no shares to borrow. If that’s the case, you’ll have to find another stock or another strategy this time.
Once the shares are sold, you wait until the security goes down in price, then you buy the shares in the market at a bargain. These purchased shares are then returned to the broker to pay the loan, and you keep the difference between where you sold and where you bought — less interest, of course.
The stock exchanges are in the business of helping companies raise money, so they have rules in place to help maintain an upward bias in the stock market. That can work against the short seller. The key regulation is what’s called the uptick rule, which means you can only sell a stock short when the last trade was a move up. You can’t short a stock that’s moving down.
Figure shows how short selling works. The trader borrows 400 shares selling at $25 each and then sells them. If the stock goes down, she can buy back the shares at the lower price, making a tidy profit. If the stock stays flat, she loses money because the broker will charge her interest based on the value of the shares she borrowed. And if the stock price goes up, she not only loses money on the interest expense, but she is also out on her investment.
The interest and fees that the broker charges those who borrow stock accrue to the broker, not to the person who actually owns the stock. In fact, the stock’s owner will probably never know that his shares were loaned out.
Investors — those people who do careful research and expect to be in their positions for months or even years — look for companies that have inflated expectations and are possibly fraudulent. Investors who work the short side of the market spend hours, usually doing careful accounting research, looking for companies that are likely to go down in price some day.
Day traders don’t care about accounting. They don’t have the time to wait for a short to work out. Instead, they are looking for stocks that go down in price for more mundane reasons, like more sellers than buyers in the next ten minutes. Most day traders who sell short simply reverse their long strategy. For example, some day traders like to buy stocks that have gone down for three days in a row, figuring that they’ll go up on the fourth day. They’ll also short stocks that have gone up three days in a row, figuring that they’ll go down on the fourth day. You don’t need a CPA to do that!
Short squeezes and other risks
Shorting stocks carries certain risks, because a short sale is a bet on things going wrong. In theory, there’s no limit on how much a stock can go up, so there is no limit on how much money a short seller can lose. Two traps in particular can get a short seller. The first is a short squeeze due to good news, the second is a concerted effort to hurt those who are short.
Squeeze my shorts
With a short squeeze, a company that has been popular with a lot of short sellers has some good news that drives the stock price up. When the price goes up, short sellers lose money, and some may even have margin problems. And the original reason for going short may be proven to be wrong. Those who are short start buying the stock back in order to reduce their losses, but their increased demand drives the stock price even higher, causing even bigger losses for those who are still short. Ouch!
Calling back the stock
All is not sweetness and light in the world of short selling. Many market participants distrust those folks who are doing all the careful research, in part because they are often right. Company executives are often optimists who don’t like to hear bad news, and they’ll blame short sellers for all that is wrong with their stock price.
Meanwhile, some short sellers have been known to get impatient if their sale isn’t making money and start spreading ugly rumors. Many companies, brokers, and investors hate short sellers and try tactics to bust them. Sometimes they issue good news or spread rumors of good news to create a squeeze. Other times, they collectively ask holders of the stock to request that their brokerage firm not loan out their shares. This means that those who shorted it have to buy back and return the shares even if it makes no sense to do so.
Lots to Discover About Leverage
Leverage is the use of borrowed money to increase returns. Day traders use it a lot to get bigger returns from relatively small price changes in the underlying securities. And as long as they consistently close their positions out at the end of the day, day traders can borrow more money and pay less interest than people who hold securities for a longer term.
The process of borrowing works differently in different markets. In the stock and bond markets, it’s straightforward. You just tell your broker you’re borrowing when you place the order. In the options and futures markets, you’re buying and selling contracts that have leverage built into them. You don’t borrow money outright, but you can control a lot of value in your account for relatively little money down.
In stock and bond markets
Leverage is straightforward for buyers of stocks and bonds: You simply click the box marked “Margin” when you place your order, and the brokerage firm loans you money. Then, when the security goes up in price, you get a greater percentage return because you’ve been able to buy more for your money. Of course, that also increases your potential losses.
Figure shows how it works. The trader borrows money to buy 400 shares of SuperCorp. If the stock goes up 4 percent, she makes 8 percent. Whoo-hooo! But if the stock goes down 4 percent, she still has to repay the loan at full dollar value, so she ends up losing 8 percent. That’s not so good.
If you hold your margin position overnight or longer, you’ll have to start paying interest. That will cut into your returns or increase your losses.
In options markets
An option gives you the right, but not the obligation, to buy or sell a stock or other item at a set price when the contract expires. A call option gives you the right to buy, so you would buy a call if you think the underlying asset is going up. A put option gives you the right to sell, so you would buy a put if you think the underlying asset is going down. By trading an option, you get exposure to changes in the price of the underlying security without actually buying the security itself. That’s the source of the leverage in the market.
A day trader might use options to get an exposure to price changes in a stock for a lot less money than it would cost to buy the stock itself. Suppose a call option is deeply in-the-money. That means that its strike price, the price that you would be able to buy the stock at if you exercised the option, is far below the current stock price. If this happens, the obvious thing is for the option price to be set at the difference between the current stock price and the strike price, and that’s more or less what happens: more in theory, less in practice. When the stock price changes, the option price changes at almost exactly the same amount. This means that you can buy the price performance of the stock at a discount, the discount being the strike price of the stock.
Figure shows the performance-boosting leverage from this strategy. The trader buys call options with an exercise price of $10 on a stock trading at $25. The option price changes the same amount that the stock price does, but the call holder gets a greater percentage return than the stock holder.
There are many other options strategies that day traders can use, but a discussion of them goes beyond the scope of this book. The Appendix has some resources to help you in your research.
In futures trading
A futures contract gives you the obligation to buy or sell an underlying financial or agricultural commodity, assuming you still hold the contract at the expiration date. That underlying product ranges from the value of treasury bonds to barrels of oil and heads of cattle, and you’re only putting money down now when you purchase the contract. You don’t have to come up with the full amount until the contract comes due — and almost all options and futures traders close out their trades long before the contract expiration date.
Although most options and futures contracts settle with cash long before the due date, contract holders have the right to hold them until the due date and, in the case of options on common stock and agricultural derivatives, demand physical delivery. It’s rare, but the commodity exchanges have systems in place for determining the transport, specifications, and delivery of grain, cattle, or ethanol. One advantage of day trading is that you close out the same day, without ever even thinking about the fine print of physical delivery.
Because derivatives have built-in leverage that allows a trader to have big market exposure for relatively few dollars up front, they’ve become popular with day traders. Figure shows how it works. Here, a trader is buying the Chicago Mercantile Exchange’s E-Mini S&P 500 futures contract, which gives traders exposure to the performance of the Standard and Poor’s 500 Index, a standard measure of the stock performance of a diversified list of 500 large American companies. The futures contract trades at 50 times the value of the index, rounded to the nearest $0.25. The minimum margin that a trader must put down on the contract is $3,500. Each $0.25 change in the index leads to a $12.50 ($0.25 × 50) change in the value of the contract, and that $12.50 is added to or subtracted from the $3,500 margin.
Some exchanges use the term margin, and others prefer to use performance bond. Either way, it’s the same thing: money you put in up front to ensure that you can meet the contract terms when it comes due. If you hold the contract overnight, your account is adjusted up or down to reflect the day’s profits. If it gets too low, you’re asked to add more money.
In foreign exchange
The foreign exchange, or forex, market is driven by leverage. Exchange rates tend to move slowly, by as little as a tenth or even a hundredth of a penny a day. And the markets are so huge that it’s easier to hedge risk. You might have trouble borrowing shares of stock to short them, but you should have no trouble ever borrowing yen. In order to get a big return, forex traders almost always borrow huge amounts of money.
In the stock market, day traders can borrow up to three times the amount of cash and securities held in their accounts (although not all firms will let you borrow the statutory maximum), and that amount is set by outside regulatory organizations. In the forex market, there is no regulation on lending, and some forex firms will allow traders to borrow as much as 400 times the amount in their accounts.
Forex firms allow such huge borrowing because they can hedge their risks, so that if you lose money, they make money. If you sell dollars to buy euros, the firm can easily go in and sell euros to buy dollars. That makes its position net neutral. If the euro goes down relative to the dollar, you’ve lost money, but the firm can offset its risk because its counter-trade went up.
The reason that a forex firm wants to hedge its risks against its day trading customers is that most day traders lose money. The firms know that if they bet against the aggregate trades held by their customers, they’ll probably come out ahead. Don’t trade in forex or any other market until you’ve worked out a strategy and practiced it, so that you can avoid becoming a statistic.
Figure shows how leverage in foreign exchange makes good returns possible. Here, the trader starts with a $1,000 account and borrows the maximum amount the forex firms allow, $400 for each dollar in the account. All $401,000 are put to work buying euros. Note that the euro value stays constant, but the dollar value of those euros changes by hundredths of a penny. Thanks to leverage, the return is 11 percent — not bad for a day’s trading! Of course, you could lose 11 percent, which wouldn’t be so good.
An exchange rate is just the price of money. If the dollar/euro rate is .7477, that means that $1.00 will buy 0.7477.
Borrowing in Your Trading Business
Leverage is only part of the borrowing involved in your day trading business. Like any business owner, sometimes you need more cash than your business generates. Other times, you see expansion opportunities that require more money than you have on hand. In this section, I discuss why and how day traders can borrow money over and above leveraged trading.
Margin loans for cash flow
If day trading is your job, then you face a constant pressure: How do you cover the costs of living while keeping enough money in the market to trade? One way to do this is to have another source of income — from savings, a spouse, or a job that doesn’t overlap with market hours. Other day traders take money out of their trading account.
If the market hasn’t been cooperative, then there might not be enough to take out of the account while still having enough capital to trade. One option is to arrange a margin loan through a brokerage firm. The firm will let you take out a loan against the securities that you hold. You can spend the money any way you like, but you will be charged interest — and you will have to repay it. Still, it’s a good option to have, because day trade earnings tend to be erratic.
Borrowing for trading capital
Some day traders use a double layer of leverage: They borrow the money to set up their trading accounts and then they borrow money for their trading strategies. If the market cooperates, this can be a great way to make money, but if not, you could end up owing a lot of people money that you don’t have.
If you want to take the risk, though, you have a few resources to turn to other than your relatives: You can borrow against your house, use your credit cards, or find a trading firm that will give you some money to work with.
Borrowing against your house
Yes, you can use a mortgage or a home equity line of credit to get the money for your day trading activities. In general, this carries low interest rates because your house is your collateral. In most cases, though, the interest will not be tax deductible (ask your accountant, but generally, you can only deduct interest used to purchase or improve your house). Still, it can be a relatively low-cost way to pull value stored in your house for use in trading. The risk? If you can’t pay back the loan, you can lose your residence. Just don’t borrow against your car, too, as you’ll need a place to live when the bank evicts you.
Putting it on the card
The business world is filled with people who started businesses using credit cards. And you can do that. If you have even halfway decent credit, credit card companies are happy to lend you all the money you want.
Naturally, they charge you a mighty high rate of interest, one that even the sharpest traders will have trouble covering from their returns. If the only way you can raise the capital for day trading is through your credit card, consider waiting a few years and saving your money before taking the plunge. Because day trading income can be erratic, you may end up using your credit cards to cover your living expenses some months. You may want to save your credit for that rather than dedicate it directly for your day trading.
Risk capital from an arcade
I discuss trading arcades, office spaces where traders can rent space. These are usually located in major cities near established stock, bond, options, and futures exchanges. Some trading arcades offer more than just desk space. Some have training programs, whereas others give promising traders some capital to trade in exchange for a cut of the profits. This may be an option for you to consider if you are new to day trading and want to put more money to work than you currently have available.
Assessing Risks and Returns from Short Selling and Leverage
Leverage introduces risk to your day trading, and that can give you greatly increased returns. Most day traders use leverage, at least part of the time, in order to make their trading activities pay off in cold, hard cash. The challenge is to use leverage responsibly. I cover the two issues most related to leverage: losing your money, and losing your nerve. Understanding those risks can help you determine how much leverage you should take, and how often you can take it.
Losing your money
Losing money is obvious. Leverage magnifies your returns, but it also magnifies your risks. Any borrowings have to be repaid regardless. If you buy or sell a futures or options contract, you are legally obligated to perform, even if you have lost money. That can be really hard. Day trading is risky in large part because of the amount of leverage used. If you don’t feel comfortable with that, you may want to use little or no leverage, especially when you are new to day trading or when you are starting to work a new trading strategy.
Losing your nerve
The basic risk and return of your underlying strategy isn’t affected by leverage. If you expect that your system will work about 60 percent of the time, then that should hold no matter how much money is at stake or where that money came from. However, it’s likely that it does make a difference to you on some subconscious level if you have borrowed the money.
Trading is very much a game of nerves. If you hesitate to make a trade, cut a loss, or otherwise follow your strategy, you’re going to run into trouble.
Let’s say you are trading futures and decide to accept three downticks before selling, and that you will look for five upticks before selling. This means you are willing to accept some loss, cut it if it gets out of hand, and then be disciplined about taking gains when you get them. This strategy keeps a lid on your losses while forcing some discipline on your gains.
Now, suppose you are dealing with lots and lots of leverage. Suddenly, those downticks become too real to you — it’s money you don’t have. Next thing you know, you only accept two downticks before closing out. But this keeps you from getting winners. Then you decide to ride with your winners, and suddenly you aren’t taking profits fast enough, and your positions move against you. Your fear of loss is making you sloppy. That’s why many traders find it better to borrow less money and stick to their system, rather than borrow the maximum allowed and let that knowledge cloud their judgment.
Lenders can lose their nerve, too. Your brokerage firm might close your account because of losses, even though waiting just a little longer might turn a losing position into a profit. (See the earlier sidebar “The dangers of risk: Long-Term Capital Management.”) That fund was shut by lenders worried about not being repaid. There’s some evidence that if the fund had been allowed to borrow more money, it would have turned a big profit in 1998.