SIGNING UP FOR ASSET CLASSES
SIGNING UP FOR ASSET CLASSES
It’s one thing to day trade, but what are you going to trade? Stocks, pork bellies, or baseball cards? You have myriad choices, but you have to choose so that you can learn the market, know what changes to expect, and make your trades accordingly. And, to avoid of the devilment of the wash-sale rule, which can limit the tax deductibility of short-term losses, you’ll probably want to make your universe of trading assets as broad as possible.
Still, you can’t trade everything. There are only so many hours in a day and only so many ideas you can hold in your head at any one time. Furthermore, some trading strategies lend themselves better to certain types of assets than others. By learning more about all the various investment assets available to a day trader, you can make better decisions about what you want to trade and how you want to trade it.
What Makes a Good Day Trading Asset
In academic terms, the universe of investable assets includes just about anything you can buy at one price and sell at another, potentially higher price. That means artwork and collectibles, real estate, and private companies would all be considered to be investable assets
Day traders have a much smaller group of assets to work with. It’s not realistic to expect a quick one-day profit on price changes in real estate. Online auctions for collectible items take place over days, not minutes. If you’re going to day trade, you want to find assets that trade easily, several times a day, in recognized markets. In other words, you want liquidity. As an individual trading your own account, you want assets that can be purchased with relatively low capital commitments. And finally, you may want to use leverage — borrowed money — to improve your return, so you want to look for assets that can be purchased using other people’s money.
Liquidity is the ability to buy or sell an asset in large quantity without affecting the price levels. Day traders look for liquid assets so they can move in and out of the market quickly without disrupting price levels. Otherwise, they may not be able to buy at a good price or sell when they want.
At the most basic level, financial markets are driven by supply and demand. The more of an asset supplied in the market, the lower the price; the more of an asset that people demand, the higher the price. In a perfect market, the amount of supply and demand is matched so that prices don’t change. This happens if there is a high volume of people trading, so that their supply and demand is constantly matched, or if there is a very low frequency of trades, so that the price never changes.
You may be thinking, wait, don’t I want big price changes so that I can make money quickly? Yes, you want price changes in the market, but you don’t want to be the one causing them. The less liquid a market is, the more likely your buying and selling is going to affect market prices, and the smaller your profit will be.
Volume is the total amount of a security that trades in a given time period. The greater the volume, the more buyers and sellers are interested in the security, and the easier it is to get in there and buy and sell without affecting the price.
Day traders also look at the relationship between volume and price. This is an important technical indicator. The simple version is this:
- High volume with no change in price levels means that there is an equal match between buyers and sellers.
- High volume with rising prices means that there are more buyers than sellers, so the price will continue going up.
- High volume with falling prices means that there are more sellers than buyers, so the price will keep going down.
Another measure of liquidity is frequency, or how often a security trades. Some assets, like stock market futures, trade constantly, from the moment the market opens until the very last trade of the day, and then continue into overnight trading. Others, like agricultural commodities, trade only during market hours or only during certain times of the year. Other securities, like stocks, trade frequently, but the volume rises and falls are regular intervals related to such things as options expiration (the date at which options on the stock expire).
The more frequently a security trades, the more opportunities you’ll have to identify the short-term profit opportunities that make day trading possible.
Volatility, standard deviation, and variance
The volatility of a security is how much the price varies over a period of time. It tells you how much prices fluctuate and thus how likely you are to be able to take advantage of that. For example, if a security has an average price of $5 but trades anywhere between $1 and $14, it will be more volatile than one with an average price of $5 that trades between $4 and $6.
One standard measure of volatility and risk is standard deviation, which is how much any given price quote varies from a security’s average price. If you are dying to see it, the math is shown in Figure, but you can calculate it with most spreadsheet programs and many trading platforms.
For each of the prices, you’d calculate the difference between it and the average value. So if the average price is $5, and the closing price today is $8, the difference would be $3. (More likely, the research service that you use would calculate the difference for you).
After you have all the differences between the prices and the average, you’d find the square of these differences. If the difference for one day’s price is $8, then the square would be $64. You’d add up all the squared differences over the period of time that you are looking at and then find the average of them. That number is called the variance, or σ2 . Finally, calculate the square root of the variance, and you have the standard deviation.
The higher the standard deviation, the higher the volatility, the higher the volatility, the more a security’s price is going to fluctuate, and the more profit — and loss — opportunities there are for a day trader.
Standard deviation is also a measure of risk that can be used to evaluate your trading performance.
You don’t necessarily need a lot of money to begin day trading, but you do need a lot of money to buy certain securities. Stocks generally trade in round lots, which are orders of at least 100 shares. If you want to buy a stock worth $40 per share, you need $4,000 in your account. Your broker will probably let you borrow half of that money, but you still need to come up with the other $2,000.
Options and futures trade by contract, and one contract represents some unit of the underlying security. For example, in the options market, one contract is good for 100 shares of the stock. These contracts also trade in round lots of 100 contracts per order.
No one will stop you from buying a smaller amount than the usual round lot in any given security, but you’ll probably pay a high commission and get worse execution for your order. Because the returns on each trade tend to be small anyway, don’t take up day trading until you have enough money to trade your target asset effectively. Otherwise, you’ll pay too much to your broker without getting much for yourself.
Bonds do not trade in fractional amounts; they trade on a per-bond basis, and each bond has a face value of $1,000. Some trade for more or less than that, depending on how the bond’s interest rate differs from the market rate of interest, but the $1,000 is a good number to keep in mind when thinking about capital requirements. Many dealers have a minimum order of 10 bonds, though, so a minimum order would be $10,000.
Most day traders make money through a large volume of small profits. One way to increase the profit per trade is to use borrowed money in order to buy more shares, more contracts, or more bonds. Margin is money in your account that you borrow against, and almost all brokers will be happy to arrange a margin loan for you, especially if you’re going to use the money to make more trades and generate more commissions for the brokerage firm. I discuss how margin is used within an investment strategy. Here, though, you want to think about how margin affects your choice of assets for day trading.
Generally, a stock or bond account must hold 50 percent of the purchase price of securities when you borrow the money. So if you want to buy $100 worth of something on margin, you need to have $50 in your account. 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.
Margin requirements aren’t set by the brokerage firms. Instead, the minimum amount in your account — and thus the maximum amount you can borrow — is set by the Federal Reserve Board. That’s because of concerns that if too much borrowing takes place, the borrowers will panic in a financial downturn and drag the market down even further. (Excessive trading on margin was a contributing factor to the stock market crash of 1929, in which the Dow Jones Industrial Average fell 13 percent in one day, and the market did not fully recover until 1954.) The Fed limits the amount that can be borrowed, and the different exchanges monitor how member brokerage firms comply. Some brokerage firms set margin limits that are higher than those of the Federal Reserve Board and the exchanges.
You probably think that the 1929 crash was responsible for the Great Depression of the 1930s, right? Think again. Most economic historians believe that the crash was a distraction. Instead, the real problem was that interest rates fell so rapidly that banks refused to lend money, while prices fell so low that companies had no incentive to produce. It’s a situation known as deflation, and it’s relatively rare, but it is devastating when it occurs.
Most stocks and bonds are marginable (able to be purchased on margin), and the Federal Reserve Board allows traders to borrow up to 50 percent of their value. But not all securities are marginable. Stocks priced below $5 per share, those traded on the OTC Bulletin Board or Pink Sheets, and those in newly public companies often cannot be borrowed against or purchased on margin. Your brokerage firm should have a list of securities that are not eligible for margin.
If leverage is going to be part of your day-trading strategy, be sure that the assets you plan to trade are marginable.
Securities and How They Trade
In the financial markets, people buy and sell securities every day, but just what are they buying or selling? Securities are financial instruments. In the olden days, they were pieces of paper, but now they are electronic entries that represent a legal claim on some type of underlying asset. This asset may be a business, if the security is a stock, or it may be a loan to a government or a corporation, if the security is a bond. In this section, I cover different types of securities that day traders are likely to run across and tell you what you need to jump into the fray.
In practice, asset and security are synonyms, and derivative is considered to be a type of asset or security. But to be precise, these three are not the same:
- An asset is a physical item. Examples include a company, a house, gold bullion, or a loan.
- A security is a contract that gives someone the right of ownership of the asset, such as a share of stock, a bond, a promissory note.
- A derivative is a contract that draws its value from the price of a security.
A stock, also called an equity, is a security that represents a fractional interest in the ownership of a company. Buy one share of Microsoft, and you are an owner of the company, just as Bill Gates is. He may own a much larger share of the total business, but you both have a stake in it. Stockholders elect a board of directors to represent their interests in how the company is managed. Each share is a vote, so good luck getting Bill Gates kicked off of Microsoft’s board.
A share of stock has limited liability. That means that you can lose all of your investment, but no more than that. If the company files for bankruptcy, the creditors cannot come after the shareholders for the money that they are owed.
Some companies pay their shareholders a dividend, which is a small cash payment made out of firm profits. Because day traders hold stock for really short periods of time, they don’t normally collect dividends.
How U.S. stocks trade
Stocks are priced based on a single share, and most brokerage firms charge commissions on a per-share basis. Despite this per-share pricing, stocks are almost always traded in round lots of 100 shares. The supply and demand for a given stock is driven by the company’s expected performance.
A stock’s price is quoted with a bid and an ask.
- The bid is the price that the broker will buy the stock from you if you are selling.
- The ask is the price that the broker will charge you if you are the one buying.
I remember the difference between the bid and the ask this way: the broker buys on the bid. Let alliteration be your friend!
The difference between the bid and the ask is the spread, and that represents the dealer’s profit.
Here is an example of a price quote:
MSFT $27.70 $27.71
That is a quote for Microsoft (ticker symbol: MSFT). The bid is listed first: $27.70; and the ask is $27.71. That’s the smallest spread you’ll ever see! The spread here is so small because Microsoft is a liquid stock, and there are no big news events going on that might change the balance of buyers and sellers.
The brokerage firm makes money from the commission and from the spread. Many novice day traders focus on the amount of the commission and forget that some brokerage firms can execute the order better than others, thus keeping the spread narrower. You need to consider the total cost of trading when you design a trading strategy and choose a brokerage firm.
I tend to use the words broker and dealer interchangeably, but there is a difference. A broker simply matches buyers and sellers of securities, whereas a dealer buys and sells securities out of its own account. Almost all brokerage firms are both brokers and dealers.
Where U.S. stocks trade
U.S. stocks trade mostly on organized exchanges such as the New York Stock Exchange and NASDAQ, but more and more they trade on electronic communications networks, some of which are operated by the exchanges themselves. Brokerage firms either belong to the exchanges themselves or work with a correspondent firm that handles the trading for them, turning over the order in exchange for a cut of the commission.
When you place an order with your brokerage firm, the broker’s trading staff executes that order wherever it can get the best deal. But is that the best deal for you, or for the brokerage firm? It’s tough to know the right answer. In general, firms that do more trading and participate in several exchanges and electronic communications networks can get you the best execution.
The financial markets are in a state of flux, with a lot of mergers and acquisitions among the exchanges. The information here might be obsolete when you read it, which I think is fascinating. It wasn’t so long ago that these exchanges were staid organizations run like private clubs.
The New York Stock Exchange (NYSE)
The New York Stock Exchange is the Big Kahuna of stock exchanges. Most of the largest U.S. corporations trade on it, and they pay a fee for that privilege. The 2,000 or so companies listed on the exchange are known by their ticker symbols, shorthand for the company name. On the New York Stock Exchange, all ticker symbols have three letters or fewer, and many old companies have one-letter symbols, like F for Ford and T for AT&T.
Two of the largest companies in the world, Intel and Microsoft, are not listed on the New York Stock Exchange, and supposedly, exchange officials have told both companies that if they move to the NYSE, they can have the ticker symbols I and M, which were unassigned for decades. In 2007, the NYSE gave the M symbol to Macy’s, formerly Federated Stores, but as this book was going to press, Macy’s was rumored to be acquired by a private equity firm, so M may be available once again to tantalize Mr. Gates and company.
In order to be listed on the New York Stock Exchange, a company generally needs to have at least 2,200 shareholders, trade at least 100,000 shares a month, carry a market capitalization (number of shares outstanding multiplied by price per share) of at least $100 million, and post annual revenues of at least $75 million.
The New York Stock Exchange is more than 200 years old, but it has been going through some big corporate changes in order to stay relevant. It’s a floor-based exchange. The trading area is a big open space in the building, known as the floor. The floor broker, who works for the member firm, receives the order electronically and then takes it over to the trading post, which is the area on the floor where the stock in question trades. At the trading post, the floor broker executes the order at the best available price.
The American Stock Exchange (AMEX)
The American Stock Exchange is a floor-based exchange also headquartered in New York City. Like the New York Stock Exchange, floor brokers receive orders and take them to trading posts to be filled. AMEX specializes in commodity companies — those that mine metals or pump out oil — but there are some other types of businesses listed on it. Listed companies have two- or three-letter ticker symbols and generally are profitable, have a market capitalization (number of shares outstanding multiplied by price per share) of atleast $75 million, and have a price per share of at least $2.00. These companies tend to be smaller and more speculative than New York Stock Exchange companies.
NASDAQ used to stand for the National Association of Securities Dealers Automated Quotation System, but now it’s just a name, not an acronym, pronounced just like it’s spelled. When NASDAQ was founded, it was an electronic communication network (more on those below) that handled companies that were too small or too speculative to meet New York Stock Exchange or American Stock Exchange listing requirements. What happened was that brokers liked using the NASDAQ network, while technology companies (Microsoft, Intel, Oracle, Apple) that were once small and speculative became huge international behemoths. But the management teams of these companies saw no reason to change how they were listed.
NASDAQ companies have four-letter ticker symbols. When a customer places an order, the brokerage firm looks to see whether there is a matching order on the network. Sometimes, it can be executed electronically; in other cases, the brokerage firm’s trader needs to call other traders at other firms to see whether the price is still good. A key feature of NASDAQ is its market makers, who are employees of member brokerage firms who agree to buy and sell minimum levels of specific stocks in order to ensure that there is some basic level of trading taking place.
NASDAQ divides its listed companies into three categories:
- The NASDAQ Global Select Market includes the 1,000 largest companies on the exchange and has high governance and liquidity standards for participating firms.
- The NASDAQ Global Market includes companies that are too small for the Global Select Market, but that in general have a market capitalization of at least $75 million, at least 1.1 million shares outstanding, at least 400 shareholders, and a minimum price per share of $5.00.
- The NASDAQ Capital Market is for companies that do not qualify for the NASDAQ Global Market. To qualify here, companies need a market capitalization of at least $50 million, at least one million shares outstanding, about 300 shareholders, and a minimum price per share of $4.00.
Day traders will find that NASDAQ Global Select Market companies are the most liquid. They may also notice changes in trading patterns when a company is close to being moved between categories. An upgrade is a sign of good news to come and increased market interest. A downgrade means that the company most likely isn’t doing well and will be of less interest to investors.
Over-the-Counter Bulletin Board (OTC BB)
The Over-the-Counter Bulletin Board is the market for companies that are reporting their financials to the U.S. Securities and Exchange Commission but that do not qualify for listing in any NASDAQ category. It also includes some foreign issuers that have not received listing in a U.S. market. American Bulletin Board companies have four-letter ticker symbols followed by .OB. For example, Vertical Communication’s ticker symbol is VRCC.OB. Foreign issuers trade with five-letter symbols — four letters followed by an F. ACS Motion Control, based in Israel, trades as ACSEF.
Brokerage firms get quotations on OTC BB stocks through their NASDAQ workstation or other quotation services, so that they can find current prices and locate buyers and sellers for any orders that they have.
In many cases, OTC BB companies are those that used to be on NASDAQ but that have lost too much money to maintain their listing. A Bulletin Board listing is often a last hurrah before oblivion.
Once upon a time, there were few electronic networks, and there was not room for many companies to trade on them. Smaller companies did not trade daily. To find current prices, brokerage firms subscribed to a price service that sent out a weekly newsletter listing the prices for those companies. The newsletter was printed on pink paper, so it became known as the Pink Sheets.
Over the years, NASDAQ expanded and added more listing opportunities for companies, and the Over-the-Counter Bulletin Board was created for companies that had to file with the Securities and Exchange Commission but that did not qualify for NASDAQ. The universe of companies that did not qualify for one of these quotation systems was very small. The Pink Sheets went online so that people could get more regular price information.
Pink Sheet companies do not have listing requirements. Most do not qualify for listing on the NASDAQ or OTC BB, usually because they are not current on their filings with the Securities and Exchange Commission. These companies have four- or five-letter ticker symbols and are sometimes shown with the suffix .PK after the ticker. Orders for Pink Sheet companies are placed through brokerage firms who use the service to find prices and match buyers and sellers.
Not all Pink Sheet companies are legitimate. Because of the minimal listing requirements, the Pink Sheets tend to be the hangout for the penny stock (those trading at less than $1.00 per share), the fraudulent company, and the security that’s easily manipulated by a boiler-room operator. It can be a tough crowd, and a lot of people get burned.
Electronic Communication Networks (ECN)
In addition to all the exchanges and listing categories, companies titanic and tiny also trade on various electronic communication networks, or ECNs. Brokerage firms and such large institutional investors as mutual fund companies subscribe to them in order to trade securities without having to pay exchange fees or commissions. ECNs are also used to trade when the market is closed. Subscribers look to see whether the ECN has a match for their orders; if so, the orders are executed automatically.
Electronic communication networks can be huge. NASDAQ, for example, is used by almost every brokerage firm in the United States, and the New York Stock Exchange acquired Archipelago, an ECN now known as NYSE Arca. Other ECNs are smaller and may combine only a few brokerage firms. In most cases, day traders can’t access these networks directly, but instead will access them through their brokerage firms.
A bond is a loan. The bond buyer gives the bond issuer money. The bond issuer promises to pay interest on a regular basis. The regular coupon payments are why bonds are often called fixed income investments. Bond issuers repay the money borrowed — the principal — on a predetermined date, known as the maturity. Bonds generally have a maturity of more than ten years; shorter-term bonds are usually referred to as notes, and bonds that will mature within a year of issuance are usually referred to as bills. Most bonds in the United States are issued by corporations (corporate bonds) or by the Federal government (Treasury bonds). Some are issued by local governments (municipal bonds).
The interest payments on a bond are called coupons. If you look on a bulletin board in a coffee shop or other community space, you’ll probably see a “car for sale” or “apartment for rent” sign with little slips of paper carrying a phone number or email address cut into the bottom. If you are interested, you can rip off the slip and contact the advertiser later. Bonds used to look the same. The bond buyer would receive one large certificate good for the principal, with a lot of smaller certificates, called coupons, attached. When a payment was due, the owner would cut off the matching coupon and deposit it in the bank. (Some old novels refer to rich people as “coupon clippers,” meaning that their sole labor in life was to cut out their bond coupons and cash them in. Nowadays, bond payments are handled electronically, so the modern coupon clipper is a bargain hunter looking for an extra 50 cents off a jar of peanut butter.)
Over the years, enterprising financiers realized that some investors needed regular payments, but others wanted to receive a single sum at a future date. So they separated the coupons from the principal. The principal payment, known as a zero-coupon bond, is sold to one investor, while the coupons, called strips, are sold to another investor. The borrower makes the payments just like with a regular bond. (Regular bonds, by the way, are sometimes called plain vanilla.)
The borrower who wants to make a series of payments with no lump-sum principal repayment would issue an amortizing bond to return principal and interest on a regular basis. If you think about a typical mortgage, the borrower makes a regular payment of both principal and interest. This way, the amount owed gets smaller over time so that the borrower does not have to come up with a large principal repayment at maturity.
Other borrowers would prefer to make a single payment at maturity, so they issue discount bonds. The purchase price is the principal reduced by the amount of interest that otherwise would be paid.
If a company goes bankrupt, the bondholders get paid before the shareholders. In some bankruptcies, the bondholders take over the business, leaving the current shareholders with nothing.
How bonds trade
Bonds often trade as single bonds, with a face value of $1000, although some brokers will only take on minimum orders of ten bonds. They do not trade as frequently as stocks do because most bond investors are looking for steady income, so they hold their bonds until maturity. Bonds have less risk than stocks, so they show less price volatility. The value of a bond is mostly determined by the level of interest rates in the economy. As rates go up, bond prices go down; when rates go down, bond prices go up. Bond prices are also affected by how likely the loan is to be repaid. If traders don’t think that the bond issuer will pay up, then the bond price will fall.
Generally speaking, only corporate and municipal bonds have repayment risk. It’s possible that the U.S. government could default, but that’s unlikely as long as it can print money. Most international government bonds have similarly low default risk, but some countries have defaulted. The most notable was Russia, which refused to print money to repay its debts in the summer of 1998. This caused huge turmoil in the world’s financial markets, including the collapse of a major hedge fund, Long-Term Capital Management.
Investment banks and the Federal government sell new bonds directly to investors. After they are issued, bonds are said to trade in the secondary market — some are listed, some trade over-the-counter, meaning dealers trade them amongst themselves rather than over an organized exchange.
A bond price quote looks like this:
3 3/4 Mar 07 n 99:28 99:29
This is a U.S. Treasury note maturing in March 2007 carrying an interest rate of 3.75 per cent. Similar to stocks, the numbers right after the “n” (for note) list the bid and ask. The first number is the bid, and it’s the price that the dealer will buy the bond from you if you are selling. The second number is the ask, and it is the price that the dealer will charge you if you are buying. The difference is the spread, and that’s the dealer’s profit.
But wait, there’s more: corporate bonds trade in eighths of a percentage point, and Treasury bonds trade in 32nds. The bid of 99:28 means that the bond’s bid price is 99 28/32 per cent of the face value of $1000, or $998.75.
Why on earth do bonds trade in eighths or fractions of eighths? Do traders just like to show off their math skills? No, it goes back to before the American Revolution. The dominant currency in most of Americas then was the Spanish doubloon, a large gold coin that could be cut into fractions to make trade easier. Like a pie, it would be cut into eight equal pieces, so prices throughout the colonies were often set in eighths. (In Robert Louis Stevenson’s book Treasure Island, the parrot keeps squawking “Pieces of eight! Pieces of eight!” This is why.)
The fractional pricing convention carried over to American securities markets, and it’s persisted because it guarantees dealers a bigger spread than pricing in decimals. After all, 1/32 of a dollar is more than 1/100. U.S. stocks were priced in sixteenths until 2001, and bond markets still maintain the old convention.
Most bonds are not suitable for day traders. Only Treasury bonds, issued by the U.S. government, have enough consistent trading volume to attract a day trader. Because of the capital required to trade and the relatively low liquidity of many types of bonds, many traders prefer to use futures to bet on interest rates.
Are you one of those day traders who wants to buy or sell bonds anyway? Or do you just want to know more about the market? Then read on.
Some larger corporate bonds are traded on the New York Stock Exchange and the American Stock Exchange. Those wanting to buy or sell them place an order through their brokerage firm, which sends an order to the floor broker. The process is almost identical to the trading of listed stocks.
Most corporate and municipal bonds trade over-the-counter, meaning there is no organized exchange. Instead, brokerage firms use electronic price services to find out where the buyers and sellers are for different issues. Over-the-counter bonds don’t trade much. Buyers often give their quality, interest rate, and maturity requirements to their broker, and the broker waits until a suitable bond comes to market.
Unlike the corporate and municipal bond market, the Treasury market is one of the most liquid in the world. The best way to buy a new Treasury bond is directly from the government, because there is no commission involved. You can get more information from the Treasury Department’s Web site, it has information on all kinds of government bonds for all kinds of purchasers.
After the bonds are issued, they trade on a secondary market of Treasury dealers. These are large brokerage firms registered with the government who agree to buy and sell bonds and maintain a stable market for the bonds If your brokerage firm is not a Treasury dealer, it has a relationship with one that it can send your order to.
Treasury dealers do quite a bit of day trading in Treasury bonds for the firm’s own account. After all, the market is liquid enough that day trading is possible. Few individual day traders work the Treasury market, though, because it requires a great deal of capital and leverage to make a high return.
Exchange traded funds (ETFs)
Exchange traded funds are a cross between mutual funds and stocks, and they offer a great way for day traders to get exposure to market segments that might otherwise be difficult to trade. A money management firm buys a group of assets — stocks, bonds, or others — and then lists shares that trade on the market. (One of the largest organizers of exchange traded funds. In most cases, the purchased assets are designed to mimic the performance of an index, and investors know what those assets are before they purchase shares in the fund.
Exchange traded funds are available on the big market indexes, like the Standard & Poor’s 500 and the Dow Jones Industrial Average. They are available in a variety of domestic bond indexes, international stock indexes, foreign currencies, and commodities.
How U.S. exchange traded funds trade
For day traders, the advantage of exchange traded funds is that they can be bought and sold just like stocks. Customers place orders, usually in round lots, through their brokerage firms. The price quotes come in decimals and include a spread for the dealer.
Where U.S. exchange traded funds trade
The firm that sets up the exchange traded fund gets to choose the market where it will trade, as long as the fund meets the exchange’s requirements for size, liquidity, and financial reporting. Exchange traded funds trade on the NYSE, the AMEX, and NASDAQ.
Cash and Currency
Cash is king, as they say. It’s money that’s readily available in your day trading account to buy more securities. For the most part, the interest rate on cash is very low, but if you are closing out your positions every night, you’ll always have a cash balance in your brokerage account. The firm will probably pay you a little interest on it, so it will contribute to your total return.
Money market accounts are boring. For day trading excitement, cash can be traded as foreign currency. Every day, trillions (yes, that’s trillions with a t) of dollars are exchanged, creating opportunities to make money as the exchange rates change. Currency is a bigger, more liquid market than the U.S. stock and bond markets combined. It’s often referred to as the forex market, short for foreign exchange.
How currency trades
The exchange rate is the price of money. It tells you how many dollars it takes to buy yen, pounds, or euros. The price that people are willing to pay for a currency depends on the investment opportunities, business opportunities, and perceived safety in each nation. If American businesses see great opportunities in Thailand, for example, they’ll have to trade their dollars for baht in order to pay rent, buy supplies, and hire workers there. This will increase the demand for baht relative to the dollar, and it will cause the baht to go up in price relative to the dollar.
Exchange rates are quoted on a bid-ask basis, just as are bonds and stocks. A quote might look like this:
USDJPY=X 118.47 118.50
This is the exchange rate for converting the U.S. dollar into Japanese yen. The bid price of 118.47 is the amount of yen that a dealer would give you if you wanted to sell a dollar and buy yen. The ask price of 118.50 is the amount of yen the dealer would charge you if you wanted to buy a dollar and sell yen. The difference is the dealer’s profit, and naturally, you’ll be charged a commission, too.
Note that with currency, you’re a buyer and a seller at the same time. This can increase the profit opportunities, but it can also increase your risk.
Day traders can trade currencies directly at current exchange rates, which is known as trading in the spot market. They can also use currency exchange traded funds or currency futures to profit from the changing prices of money.
Where currency trades
Spot currency — the real-time value of money — does not trade on an organized exchange. Instead, banks, brokerage firms, hedge funds, and currency dealers buy and sell amongst themselves all day, every day.
Day traders can open dedicated forex accounts through their broker or a currency dealer and then trade as they see opportunities during the day.
Commodities and How They Trade
Commodities are basic, interchangeable goods sold in bulk and used to make other goods. Examples include oil, gold, wheat, and lumber. Commodities are popular with investors as a hedge against inflation and uncertainty. Stock prices can go to zero, but people still need to eat! While commodity prices usually tend to increase at the same rate as in the overall economy, so they maintain their real (inflation-adjusted) value, they can also be susceptible to short-term changes in supply and demand. A cold winter increases demand for oil, a dry summer reduces production of wheat, and a civil war could disrupt access to platinum mines.
Day traders aren’t going to buy commodities outright - if you really want to haul bushels of grain around all day, you can do that without taking on the risks of day trading. You’d get more exercise, too. Instead, day traders who want to play with commodities can look to other investments. The most popular way is to buy futures contracts, which change in price with the underlying commodity. Increasingly, many trade commodities through exchange traded funds (see earlier section) that are based on the value of an underlying basket of commodities.
Derivatives and How They Trade
Derivatives are financial contracts that draw their value from the value of an underlying asset, security, or index. For example, an S&P 500 futures contract would give the buyer a cash payment based on the price of the S&P 500 index on the day that the contract expires. The contract’s value thus depends on where the index is trading. You are not trading the index itself, but rather you are trading a contract with a value derived from the price of the index. The index value changes all the time, so day traders have lots of opportunities to buy and sell.
Types of derivatives
Day traders are likely to come across three types of derivatives. Options and futures trade on dedicated derivatives exchanges, whereas warrants trade on stock exchanges.
An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon price at an agreed-upon date in the future. An option that gives you the right to buy is a call, and one that gives you the right to sell is a put. A call is most valuable if the stock price is going up, whereas a put has more value if the stock price is going down.
Here’s one way to remember the difference: you call up your friend to put down your enemy.
For example, a MSFT 2007 Mar 22.50 call gives you the right to buy Microsoft at $22.50 per share at the expiration date on the third Friday in March, 2007. (Did you know that traders refer to Microsoft as “Mr. Softy”? Clever, huh?) If Microsoft is trading above $22.50, you can exercise the option and make a quick profit. If it is selling below $22.50, you could by the stock cheaper in the open market, so the option would be worthless.
You can find great information on options, including online tutorials, at the Chicago Board Options Exchange Web site.
A futures contract gives one the obligation to buy a set quantity of the underlying asset at set price and a set future date. These started in the agricultural industry because they allowed farmers and food processors to lock in their prices early in the growing season, reducing the amount of uncertainty in their businesses. Futures have now been applied to many different assets, ranging from pork bellies (which really do trade — they are used to make bacon) to currency values. A simple example is a lock in a home mortgage rate; the borrower knows the rate that will be applied before the sale is closed and the loan is finalized. Day traders use futures to trade commodities without having to handle the actual assets.
Most futures contracts are closed out with cash before the settlement date. Financial contracts — futures on currencies, interest rates, or market index values — can only be closed out with cash. Commodity contracts may be settled with the physical items, but almost all are settled with cash. No one hauls a side of beef onto the floor of the Chicago Board of Trade!
A warrant is similar to an option, but it’s issued by the company rather than sold on an organized exchange. (After they are issued, warrants trade similarly to stocks.) A warrant gives the holder the right to buy more stock in the company at an agreed-upon price in the future.
A cousin of the warrant is the convertible bond, which is debt issued by the company. The company pays interest on the bond, and the bondholder has the right to exchange it for stock, depending on where interest rates and the stock price are. Convertibles trade on the stock exchanges.
Buying and selling derivatives
Derivatives trade a little differently than other types of securities because they are based on promises. When someone buys an option on a stock, they aren’t trading the stock with someone right now, they are buying the right to buy or sell it in the future. That means that the option buyer needs to know that the person on the other side is going to pay up. Because of that, the derivatives exchanges have systems in place to make sure that those who buy and sell the contracts will be able to perform when they have to. Requirements for trading derivatives are different than in other markets.
How derivatives trade
Well, the word margin is used differently when discussing derivatives, but that’s in part because derivatives are already leveraged — you aren’t buying the asset, just exposure to the price change, so you can get a lot of bang for your buck.
Margin in the derivatives market is the money you have to put up to ensure that you’ll perform on the contract when it comes time to execute it. In the stock market, margin is collateral against a loan from the brokerage firm. In the derivatives markets, margin is collateral against the amount you might have to pay up on the contract. The more likely it is that you will have to pay the party who bought or sold the contract, the more margin money you will have to put up. Some exchanges use the term performance bond instead.
To buy a derivative, you put up the margin with the exchange’s clearing house. That way, the exchange knows that you have the money to make good on your side of the deal — if, say, a call option that you sell is executed, or you lose money on a currency forward that you buy. Your brokerage firm will arrange for the deposit.
At the end of each day, derivatives contracts are marked-to-market, meaning that they are revalued. Profits are credited to the trader’s margin account, and losses are deducted. If the margin falls below the necessary amount, the trader will get a call and have to deposit more money.
By definition, day traders close out at the end of every day, so their options are not marked-to-market. The contracts will be someone else’s problem, and the profits or losses on the trade go straight to the margin account, ready for the next day’s trading.
Where derivatives trade
Traditionally, derivative trading involves open-outcry on physical exchanges. Traders on the floor get orders and execute them amongst themselves, shouting and using hand signals to indicate what they want to do. There is no central trading post or market maker to control the activities or guarantee a market. Most traders are employees of large commodities brokerage firms, but some are independent. No matter who employs them, traders may be executing someone else’s orders for a fee, or they may be working for proprietary accounts.
Open-outcry has fewer economies of scale than the electronic trading systems that dominate activity in other assets. That’s why there are more derivatives exchanges in the United States than active stock exchanges. Still, all the exchanges offer some electronic trading services, and that has become more and more popular. It’s also causing much restructuring and consolidation among the exchanges. As I write this, the Chicago Board of Trade is planning a merger with the Chicago Mercantile Exchange; floor traders at both exchanges have been steadily losing market share to electronic trading.
Sometimes, the people in the pits start messing around with each other, and that can cause unusual volatility in the trading of the securities. Day traders who deal in commodities will often notice short periods of irrational trading for those derivatives that trade primarily in pits. The more human involvement there is, the less efficient a market will be.
Chicago Board Options Exchange (CBOE)
The Chicago Board Options Exchange, often known by the acronym CBOE(pronounced see-bow), is the largest options market in the United States. This is where orders for stock options are traded. Brokerage firms use floor bro- kers in the trading pits or the CBOE’s electronic trading system to handle customer orders.
Chicago Board of Trade (CBOT)
At the top of the Chicago Board of Trade’s building is a statue of Ceres, the Greek goddess of grain. That’s because this is the center of futures trading in corn, wheat, rice, oats, and soybeans. The Board of Trade has branched out over the years and now offers futures contracts on financial commodities like Treasury bonds and the Dow Jones Industrial Average. Recently, it added trading in ethanol futures, an expansion from its history with corn. When a brokerage firm gets a customer order for a future traded on the Board of Trade, it can send it to floor brokers to fill in the trading pits, or it can use the exchange’s electronic trading system.
Chicago Mercantile Exchange (CME)
Futures in non-grain agricultural products, such as milk, butter, cattle, pork bellies, and fertilizer, trade at The Chicago Mercantile Exchange, known more colloquially as the Merc. Other key futures traded here include foreign exchange, interest rates, and Standard and Poor’s and NASDAQ indexes. The Merc has also added some alternative products such as futures in weather and real estate. When brokerage firms receive orders for the Merc’s futures, they send it to floor brokers, who can fill it in the trading pits, or they can use the Merc’s electronic trading system.
New York Board of Trade (NYBOT)
The New York Board of Trade was founded in 1998, when the Coffee, Sugar, and Cocoa Exchange merged with the New York Cotton Exchange. Here, traders can buy and sell futures and options on those commodities as well as on orange juice, the New York Stock Exchange, the U.S. dollar, and the euro. Orders are filled in the trading pits or through an electronic trading system.
New York Mercantile Exchange (NYMEX)
Fuels and metals trade at the New York Mercantile Exchange, which is the largest physical commodities exchange in the United States. Most trading takes place in open-outcry pits, but an electronic system is available for overnight trading.