Showing posts with label day-trading-for-beginners. Show all posts
Showing posts with label day-trading-for-beginners. Show all posts

FUN WITH REGULATION

FUN WITH REGULATION




The financial markets are wild and woolly playgrounds for capitalism at its best. Every moment of the trading day, buyers and sellers get together to figure out what the price of a stock, commodity, or currency should be at that moment, given the supply, the demand, and the information out there. It’s beautiful.

One reason the markets work so well is that they are regulated. That may seem like an oxymoron: Isn’t capitalism all about free trade, unfettered by any rules from nannying bureaucrats? Ah, but for capitalism to work, people on both sides of a trade need to know that the terms will be enforced. They need to know that the money in their accounts is there and is safe from theft. And they need to know that no one has an unfair advantage. Regulation creates the trust that makes markets function.

Day traders may not be managing money for other investors, and they may not answer to an employer, but that doesn’t mean they don’t have rules to follow. They have to comply with applicable securities laws and exchange regulations, some of which specifically address those who make lots of shortterm trades. Likewise, brokers and advisors who deal with day traders have regulations that they need to follow, and understanding them can help day traders make better decisions about whom to deal with.

How Regulations Created Day Trading

With the advent of the telegraph, traders could receive daily price quotes. Many cities had bucket shops, which were storefront businesses where traders could bet on changes in stock and commodity prices. They weren’t buying the security itself, even for a few minutes, but were instead placing bets against others. These schemes were highly prone to manipulation and fraud, and they were wiped out after the stock market crash of 1929.

After the 1929 crash, small investors could trade off the ticker tape, which was a printout of price changes sent by telegraph, or wire. In most cases, they would do this by going down to their brokerage firm’s office, sitting in a conference room, and placing orders based on the changes they saw come across the tape. Really serious traders could get a wire installed in their own office, but the costs were prohibitive for most individual investors. In any event, traders still had to place their orders through a broker rather than having direct access to the market, so they could not count on timely execution.

Another reason there was so little day trading back then is that all brokerage firms charged the same commissions until 1975. That year, the Securities and Exchange Commission ruled that this amounted to price fixing, so brokers could then compete on their commissions. Some brokerage firms, such as Charles Schwab, began to allow customers to trade stock at discount commission rates, which made active trading more profitable. (Some brokerage firms don’t even charge commissions anymore, but don’t worry; they get money from you in other ways.)

The system of trading off the ticker tape more or less persisted until the stock market crash of 1987. Brokerage firms and market makers were flooded with orders, so they took care of their biggest customers first and pushed the smallest trades to the bottom of the pile. After the crash, the exchanges and the Securities and Exchange Commission called for several changes that would reduce the chances of another crash and improve execution if one were to happen. One of those changes was the Small Order Entry System, often known as SOES, which gave orders of 1000 shares or less priority over larger orders.

Then, in the 1990s, Internet access became widely available, and several electronic communications networks started giving small traders direct access to price quotes and trading activities. This meant that traders could place orders on the same footing as the brokers they once had to work through. In fact, thanks to the SOES, the small traders had an advantage: They could place orders and then sell the stock to the larger firms, locking in a nice profit. Day trading looked like a pretty good way to make a living.

Larger institutional traders and NASDAQ market makers resented the way that traders using SOES exploited their advantage, referring to these people as SOES bandits.

Your library and bookstore might have older books talking about how day traders can make easy money exploiting SOES. That loophole is long gone, so stick to newer guides. There’s a list in the appendix.

In 2000, the Small Order Execution System (SOES) was changed to eliminate the advantage the small traders had, but few of them cared right away. More and more discount brokerage firms offered Internet trading while Internet stocks became wildly popular. No one needed SOES to make profits when Amazon.com and Webvan were going up in price day after day, at least for a while. But then reality caught up with the technology industry, and the market for those stocks cratered in 2000.

We’re now in a new era, with new trading practices and new regulation.

Who Regulates What

In the United States, financial markets get general regulatory oversight from two government bodies: the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Both have similar goals: to ensure that investors and traders have adequate information to make decisions and to prevent fraud and abuse.

Neither body has complete authority over the markets, though. Instead, much of the responsibility for proper behavior has been given to self-regulatory organizations that brokerage firms join, and to the exchanges themselves. It’s not straightforward, but the overlap between these organizations seems to ensure that problems are identified early on and that the interests of companies, brokers, and investment managers are fairly represented.

Stock and corporate bond market regulation

The stock and corporate bond markets are the most prominent. Regulators are active and visible because these markets have a relatively large number of relatively small issuers. There’s not one government issuing currency — there are a whole bunch of companies issuing shares of stock. When it turns out that one of these companies has fraudulent numbers, the headlines erupt, and suddenly everyone cares about what the SEC is up to. That’s just the first layer in regulating this market.

Given the rate at which exchanges are merging and organizations are rearranging themselves, the following list may well be obsolete by the time you read it. But even if the organizations go away, the regulations won’t.

The U.S. Securities and Exchange Commission (SEC)
   
   www.sec.gov

The SEC is a government agency that ensures that markets work efficiently. The Commission has five commissioners, appointed by the President and confirmed by Congress, who serve staggered five-year terms. This structure is designed to keep the SEC nonpartisan. One of the commissioners is designated as the chair.

The SEC has three functions:
  • To ensure that any companies that have securities listed on exchanges in the United States report their financial information accurately and on time, so that investors can determine whether investing in the company makes sense for them
  • To provide oversight to the markets by ensuring that the exchanges and self-regulatory organizations have sufficient regulations in place and that those regulations are enforced
  • To regulate mutual funds, investment advisors, and others who make decisions for other people’s money


The National Association of Securities Dealers (NASD)

   www.nasd.com

The NASD represents and regulates all stock and bond brokerage firms and their employees. More than 5,000 firms are members, with 660,000 employees registered to sell securities. The NASD administers background checks and licensing exams, regulates securities trading and monitors how firms comply, and provides information for investors so that they are better informed about the investing process.

The NASD also requires brokers to know who their customers are and whether an investment strategy is suitable for them. I discuss suitability later in this chapter, but for now, know that that’s an NASD function.

A good first stop for a day trader is the NASD’s BrokerCheck service. The Web site address is too unwieldy to reprint here, but you can go to www.nasd.org and click on the link to BrokerCheck from that home page.

BrokerCheck allows you to look up brokerage firms and individual brokers to see whether they are in good standing. If there have been any complaints filed, you can see what they are and decide for yourself how you feel about them. It’s great information that can help you head off problems early on.

The NASD started as a self-regulatory organization, but in the late 1960s it saw that member firms needed a better way to trade over-the-counter securities (securities that do not trade on an organized exchange like the New York

Stock Exchange). In 1971, it formed its own electronic communication network, the National Association of Securities Dealers Automated Quotation system, or NASDAQ, pronounced as one word: “NAZ-dack.” In 2000, the NASD divested NASDAQ, which is now known only by that name, and returned to its self-regulatory organization roots. Although the two are now separate, brokerage firms that trade securities on NASDAQ must be members of the National Association of Securities Dealers.

The exchanges

Each of the major stock and bond exchanges — the New York Stock Exchange (NYSE), the American Stock Exchange (ASE), and NASDAQ — has its own regulatory body that makes sure that companies with securities traded on the exchange meet the criteria that have been set for their listing. These criteria include timely financial reporting with the SEC and minimum numbers of shares that are actually traded.

The exchanges also monitor how securities are traded in order to look for patterns that might point to market manipulation or insider trading. Each works with brokerage firms that are allowed to trade on its exchange to make sure they know who their customers are and that they have systems in place to make certain these customers play by the rules.

The NYSE used to oversee and license brokers that worked for member firms. At the time of this writing, it is in the process of merging those functions with the NASD. As all NYSE firms are also members of the NASD, this should reduce much duplication of effort.

Treasury bond market regulation

Treasury bonds are a slightly different animal than corporate bonds. They are issued by the U.S. government, so regulation is handled by the Treasury Department’s Bureau of the Public Debt (www.treasurydirect.gov) with additional oversight from the SEC.

Derivatives market regulation

The derivatives markets, where options and futures are traded, don’t deal in stocks and bonds directly. Instead, they link buyers and sellers of contracts where the value is linked to the value of an underlying security. Derivatives are popular with day traders, because they give them a way to get exposure to interest rates and market index performance with less capital than would be required to buy treasury bonds or large groups of stocks directly.

Derivatives markets have their own regulatory bodies, but they match the format and hierarchy of stock and bond market regulation. The organizations may not be household names, but their functions will seem familiar.

Commodity Futures Trading Commission (CFTC)

   www.cftc.gov

The CFTC is a government agency founded in 1974 to oversee market activities in agricultural and financial commodities. The government realized that these markets needed some regulation but were sufficiently different from traditional stock exchanges that the SEC might not be the best agency to handle it. The CFTC is structured similarly to the SEC, with five commissioners holding staggered five-year terms, appointed by the President and confirmed by Congress. One of the commissioners is designated as the chair. This structure is designed to keep the CFTC nonpartisan.

For decades, futures trading was regulated by the U.S. Department of Agriculture, because it involved nothing but agricultural commodities like grain, pork bellies, and coffee. As traders demanded such new products as futures on interest rates and currencies, it became clear that a new regulatory body was needed, and that was the CFTC.

The CFTC has two main functions:
  • To ensure that the markets are liquid and that both parties on an options or futures transaction are able to clear (that is, to meet their contractual obligations)
  • To provide oversight to the markets by ensuring that the exchanges and self-regulatory organizations have sufficient regulations in place, and that those regulations are enforced


National Futures Association (NFA)

   www.nfa.futures.org

The NFA regulates 4,200 firms and has 55,000 employees who work on the different futures exchanges. It administers background checks and licensing exams, regulates futures trading and monitors how firms comply, and provides information for investors so that they are better informed about futures trading and how it differs from more traditional investments.

Firms that handle futures are known as futures commission merchants, or FCMs, rather than brokers. You can find information on FCMs and their employees through the NFA’s Background Affiliation Status Information Center, which has the clever acronym BASIC. You can access it at www.nfa.futures.org/ basicnet/ or through the NFA’s home page. BASIC allows you to look up futures firms and employees to see whether they are registered and whether any complaints have been filed against them. If there have been any complaints filed, you can see how the problem was resolved. It’s like that legendary permanent record that your elementary school teachers said would follow you for the rest of your life.

Trading in options on stocks is regulated by the Securities and Exchange Commission and the National Association of Securities Dealers, but trading on options on futures is regulated by the Commodity Futures Trading Commission and the National Futures Association. As the lines between derivative products get blurrier, you may find a lot of overlap, and many in the industry predict that the SEC and CFTC will merge at some point. Because it’s possible to research firms and people through several self-regulatory organizations, you may as well take the time to do it. Don’t be alarmed if someone is listed one place and not the other, but do be alarmed if a firm or person isn’t listed anywhere.

The exchanges

The Chicago Board Options Exchange (CBOE), Chicago Board of Trade (CBOT), Chicago Mercantile Exchange (CME, also called the Merc), New York Board of Trade (NYBOT), New York Mercantile Exchange (NYMEX), and other derivatives exchanges have their own regulatory groups that ensure that their traders comply with exchange rules and rules of other organizations, especially the CFTC. They also develop new types of trading contracts that satisfy market demands while complying with applicable laws.

The exchanges also monitor how derivatives are traded in order to look for patterns that might point to market manipulation or insider trading. Each works with the futures commission merchants that are allowed to trade on its exchange to make sure that they know who their customers are and that they have systems in place to make sure these customers trade well, if not profitably.

Foreign exchange (forex) regulation

Because it is the largest, most liquid market in the world, many day traders are taking up trading in foreign exchange, also known as forex. But here’s the tricky thing: These markets are not well regulated. There’s nothing to stop someone from exchanging U.S. dollars for Canadian dollars; tourists do it every day, often at a hotel desk or retail shop. There’s no paperwork, no hassle — and no oversight.

Oversight isn’t necessary for someone at a convenience store buying a tube of Smarties (no, not the horrible dry tablets wrapped in cellophane, but rather a fine chocolate candy not available in the States, so if you cross the border, please pick some up for me!) with bucks and getting loonies in return. Unfortunately, this has allowed some firms to misrepresent forex trading to day traders, and it has allowed some day traders to get badly burned. Forewarned is forearmed, as the cliché goes.

Options and futures on currency

Most currency is traded in the spot: Traders exchange one currency for another at the current exchange rate. The spot market is not regulated. But many trade currency using options and futures, to bet on where exchange rates might go and to hedge the risks of unexpected changes. Options and futures on currency are regulated as derivatives, through the CFTC, the NFA, and the relevant futures exchanges. In some cases, though, FCMs get customer referrals from foreign exchange firms that are not themselves registered, which can make it unclear whether customers understand what they are getting into.

If you are participating in an unregulated market like forex, you can protect yourself by doing your research so that you know what the risks and rewards are. For that matter, every market has a few unscrupulous individuals, so you will always be better off if you find your own facts rather than rely on someone else. The exchanges and self-regulatory organizations all have great Websites with lots of information, and you can see a directory of them in this book’s appendix.

Banks and oversight

Banks are responsible for most foreign exchange trading, and banks are heavily regulated. This means that the Federal Reserve Banks and the U.S. Treasury Department are paying attention to forex markets, looking for evidence of manipulation and money laundering. This keeps the market from being a total free-for-all, even though anyone is allowed to trade currency. Bank oversight isn’t enough to protect your from the outlandish claims from crooked forex trading firms, but it does ensure that your contracts are fulfilled.

Brokerage Basics for Firm and Customer

No matter who regulates them, brokers and futures commission merchants have to know who their customers are and what they are up to. That leads to some basic regulations about suitability, pattern day trading, and money laundering — and extra paperwork for you. Don’t get too annoyed by all the paperwork you have to fill out to open an account, because your brokerage firm has even more.

Are you suitable for day trading?

Brokerage firms and FCMs have to make sure that customer activities are appropriate. The firms need to know their customers and be sure that any recommendations are suitable. When it comes to day trading, firms need to be sure that customers are dealing with risk capital — money that they can afford to lose. They also need to be sure that the customers understand the risks that they are taking. Depending on the firm and what you are trying to do, you might have to submit financial statements, sign a stack of disclosures, and verify that you have received different guides to trading.

It’s no one’s business but your own, except of course that the various regulators want to make sure that firm employees aren’t talking customers into taking on risks that they should not be taking. Sure, you can lie about it. You can tell the broker you don’t need the $25,000 you’re putting in your account, even if that’s the money paying for your kidney dialysis. But if it’s gone, you can’t say you didn’t know about the risks involved.

Staying out of the money Laundromat

Money laundering is the process of giving a provenance to money acquired from illegal activities. Your average drug dealer, Mafia hit man, or corrupt politician doesn’t accept credit cards, but he really doesn’t want to keep lots of cash in his house. How can he collect interest on his money if it’s locked in a safe in his closet? And besides, his friends are an unsavory sort. Can he trust them to stay away from his cache? If this criminal fellow takes all that cash to the bank, those pesky bankers will start asking a lot of questions, because they know that most people pursuing legitimate business activities get paid through checks or electronic direct deposit.

Hence, the felon with funds will look for a way to make it appear that the money is legitimate. There are all sorts of ways to do this, ranging from making lots of small cash deposits to engaging in complicated series of financial trades and money transfers, especially between countries, that become difficult for investigators to trace. Sometimes these transactions look a lot like day trading, and that means that legitimate brokerage firms opening day trade accounts should be paying attention to who their customers are.

Fighting money laundering took on urgency after the September 11, 2001 attacks, because it was clear that someone somewhere had given some bad people a lot of cash to fund the preparation and execution of their deadly mission. The U.S. and several other nations increased their oversight of financial activities during the aftermath of the strikes on the World Trade Center and Pentagon. That’s why a key piece of paperwork from your broker will be the anti-money laundering disclosure. The U.S. Treasury Department’s Financial Crimes Informant Network (www.fincen.gov), which investigates money laundering, requires financial institutions to have enforcement procedures in place to verify that new investments were not made from ill-gotten funds.

In order for your brokerage firm to verify that it knows who its customers are and where their money came from, you’ll probably have to provide the following when you open a brokerage account:
  • Your name
  • Date of birth
  • Street address
  • Place of business
  • Social Security number or Taxpayer Identification Number
  • Driver’s license and passport
  • Copies of financial statements


Special rules for pattern day traders

Here’s the problem for regulators: Many day traders lose money, and those losses can be magnified by the use of leverage strategies (trading with borrowed money, meaning that you can lose more money than you have in the quest for large profits. If the customer who lost the money can’t pay up, then the broker is on the hook. If too many customers lose money beyond what the broker can absorb, then the losses ripple through the financial system, and that’s not good.

The National Association of Securities Dealers has a long list of rules that its member firms have to meet in order to stay in business. One, known as NASD Rule 2520, deals specifically with day traders. It sets the minimum account size and margin requirements for those who fit the definition of day traders, and I’ll give you a hint: The requirements are stricter than for other types of accounts, to reflect the greater risk.

The NASD defines day trading as the buying or selling of the same security on the same day in a margin account (that is, using borrowed money). Execute four or more of those day trades within five business days, and you are a pattern day trader, unless those four or more trades were 6 percent or less of all the trades you made over those five days.

The National Futures Association does not have a definition of day trading, because futures trades by their very nature are short term.

Here’s why it matters: If you are a pattern day trader, you can have margin of 25 percent in your account, which means you can borrow 75 percent of the cost of the securities that you are trading. Most customers are only allowed to borrow 50 percent. That’s because pattern day traders almost always close out their positions overnight, so there is less risk to the firm of having the loan outstanding. However, you have to have a margin account if you are a pattern day trader. This means you have to sign an agreement saying that you understand the risks of borrowing money, including that you may have to repay more than is in your account and that your broker can sell securities out from under you to ensure you pay what is owed.

Under Rule 2520, you have to have at least $25,000 in your brokerage account. If you have losses that take your account below that, you have to come up with more money before your broker will allow you to continue day trading. You can’t plead your case, because the broker has to comply with the law. In fact, if you don’t make the deposits necessary to bring your account up to at least $25,000 and at least 25 percent of the amount of money you’ve borrowed within five business days, you have to trade on a cash basis (no borrowing), assuming the firm will even let you trade.

The rules set by the NASD and other self-regulatory organizations are minimum requirements. Brokerage firms are free to set higher limits for account size and borrowing, and many do in order to manage their own risks better.

Tax reporting

On top of the identity paperwork, you have forms to fill out for tax reporting. IRS Form W9 keeps your taxpayer information on record. Then, at the end of the year, the brokerage firm sends you a 1099 form listing how much money you made in your account. After all, the taxman always gets his cut.

Hot Tips and Insider Trading

The regulations are very clear for things about suitability and money laundering. You get a bunch of forms, you read them, you sign them, you present documentation, and everyone is happy. The rules that keep the markets functioning are clear and easy to follow.

There’s another set of rules that keep markets functioning — namely, that no one has an unfair information advantage. If you knew about big merger announcements, interest rate decisions by the Federal Reserve, or a new sugar substitute that would eliminate demand for corn syrup, you could make a lot of money in the stock market, trading options on interest rate futures or playing in the grain futures market.

Insider trading is not well defined. Any non-public information that a reasonable person would consider when deciding whether to buy or sell a security would apply, and that’s a pretty vague standard — especially because the whole purpose of research is to combine bits of immaterial information together to make investment decisions.

Day traders can be susceptible to hot tips, because they are buying and selling so quickly. If these hot tips are actually inside information, though, the trader can become liable. If you get great information from someone who is in a position to know — an officer, a director, a lawyer, an investment banker — you may be looking at stiff penalties. Civil penalties are usually three times your profits, but the government might decide that your trading was part of a criminal enterprise, making the potential penalties much greater.

Insider trading is difficult to prove, so federal regulators use other tools to punish those it suspects of making improper profits. Martha Stewart wasn’t sent to prison on insider trading charges; she was charged with obstructing justice by lying to investigators about what happened.

Whenever a big announcement is made, such as a merger, the exchanges go back and review trading for several days before to see whether there were any unusual activities in relevant securities and derivatives. Then they start tracing it back to the traders involved through the brokerage firms to see if it was coincidence or part of a pattern.

The bottom line is this: You may never come across inside information. But if a tip seems too good to be true, it probably is, so be careful.

Taking in Partners

Once your day trading proves to be wildly successful, you might want to take on partners to give you more trading capital and a slightly more regular income from the management fees. You can do it, but it’s a lot of work.

If you are trading options and futures, you need to register with the National Futures Association if you’re operating a commodity pool or working as a commodity trading advisor. If you’re trading stocks and bonds, you have to register with the Securities and Exchange Commission unless you meet the exemption tests that would let you operate as a hedge fund instead.

Registration is not a do-it-yourself project. An error or omission may have tremendous repercussions, including fines or jail time, down the line. If you want to take on partners for your trading business, spend the money for qualified legal advice. It will protect you and show prospective customers that  you are serious about your business.

To qualify as a hedge fund, which is a private investment partnership that does not qualify for registration under the Investment Company Act of 1940, you have to deal only with accredited investors (those with at least $1 million in net worth or an annual income of $200,000) or qualified purchasers (those with $5 million in investable assets). The idea is that these people should have enough money to lose and be able to understand the risks that they are taking. Hedge funds do not have to register with the SEC, but they may have to register with the NFA. However, prospective investors will want to see proof that you know what you are doing and know how to handle their money. That step is beyond the scope of this book, but it’s something for a successful day trader to consider.

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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

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

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.

Frequency

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.

Capital requirements

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.

Marginability

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.

Stocks

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

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.

Pink Sheets

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.

Bonds

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.

Listed bonds

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.

Over-the-counter trading

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.

Treasury dealers

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.

Options

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.

Futures

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!

Warrants

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.


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