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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INVESTING, TRADING, AND GAMBLING

INVESTING, TRADING, AND GAMBLING




Day trading isn’t investing, nor is it gambling — at least not if done right. But the lines between the three can be thin, and if you know where they are, you’ll be in a better position to follow your trading strategy and make more money. And if you can avoid the trap of gambling, you’ll be better able to preserve your trading capital.

The difference between investing and gambling is the risk and return tradeoff. In investing, the odds are generally in your favor, but that doesn’t mean you’re going to make money. Some day traders end up gambling, and then the odds are moving against them. And unlike in the finer establishments in Las Vegas, no one is going to bring the failed day trader free drinks to help ease the pain. A lot comes down to personality; if you are on a casino’s “do not admit” list, you probably aren’t a great candidate for day trading.

This starts off with a lot of gory details about risk and return. It helps you understand how the securities markets price risk and reward those who willing to take it. Then I explain the differences in risk and reward for investors, traders, and gamblers to give you better information to help you plan your day trading.

Understanding Risk and Return

Investors, traders, and gamblers have this in common: They are putting some of their money at risk and they expect to get a return. Ideally, that return comes in the form of cold, hard cash — but at a casino, you might get your return in the form of tickets to a Celine Dion concert after you lose a lot of money at the tables.

Trading is a business: The more you know about the potential risks and the sources of your potential return, the better off you’ll be. Your risk is that you won’t get the return you expect, and your reward is that you get fair compensation for the risk you take.

What is risk, anyway?

Risk is the measurable likelihood of loss. The riskier something is, the more frequently a loss will occur, and the larger that loss is likely to be. Playing in traffic is riskier than driving in traffic, and skydiving is riskier than gardening. This doesn’t mean that you can’t have losses in a low-risk activity or big gains in a high-risk one. It just means that with the low-risk game, losses are less likely to happen, and those that do are likely to be small.

What’s the difference between risk and uncertainty? Risk involves the known likelihood of something good or bad happening so that it can be priced. What’s the likelihood of your living to be 100? Or of getting into a car accident tonight? Your insurance company knows, and it figures your rates accordingly. What’s the likelihood of aliens from outer space arriving and taking over the Earth? Who knows! It could happen, but that event is uncertain, not risky — at least until it happens.

The ability to measure risk made modern business possible. Until mathematicians were able to use statistics to quantify human activities, people assumed that bad things were simply the result of bad luck or, worse, the wrath of the gods. But when they could understand probability, it could be applied and used. If a sailor agreed to join a voyage of exploration, what was the probability that he would return home alive? And what would be fair compensation to him for that risk? What was the probability of a silo of grain going up in flames? And how much should the farmer charge the grain buyers for the risk that he was taking, and how much should someone else charge to insure the farmer against that fire?

Considering the probability of a loss

Whenever you take risk, you take on the probability of loss. If you know what that probability is, you can determine whether the terms you are being offered are fair and you have a reasonable expectation for the size of the loss.

Let’s say that you are presented with this opportunity: You put up $10. You have an 80-percent chance of getting back $11 and a 20-percent chance of losing everything. Should you take it? To find out, you multiply the expected return by the likelihood and add them together: (80% × $11) + (20% × $0) = $8.80. Your expected return of $8.80 is less than the $10 cost of this contract, so you should pass on it.

Now, suppose you are offered this opportunity: You put up $10. You have a 90-percent chance of getting back $11 and a 10-percent chance of getting back $6. Your expected return is (90% × $11) + (10% × $6) = $10.50. This contract would be in your favor, so you should take it.

Now here’s a third proposition: You put up $10. You have a 90-percent chance of getting back $13.89 and a 10-percent chance of losing $20 — even more than you put up. Your expected return is (90% × 13.89) + (10% × –$20) = $10.50. It’s the same expected return as the proposition above, but do you like it as much?

When thinking about loss, most people tend to put too much weight on the absolute dollar amount that they can lose, rather than thinking about the likelihood. The problem is that the markets don’t trade on your personal preferences. This is one of the psychological hurdles of trading that those who are successful can overcome.

Working with limited liability (usually)

Securities markets rely on the concept of limited liability. That is, you cannot lose any more money than you invested in the first place. If you buy a stock, it can go down to zero, but it can’t go any lower. If the company goes bankrupt, no one can come to you and ask you to cover the bills. On the otherhand, the most the stock can go up in price is infinity, so the possible return for your risk is huge. (Microsoft has grown more than 500-fold since it came public, which isn’t quite infinity, but I sure wish I had taken that proposition.)

Most day trading strategies have the same limited liability: You can lose what you trade, and no more. Some strategies have unlimited liability, however. If you sell a stock short (borrow shares and then sell them in hopes that the stock goes down in price, allowing you to repay the loan with cheaper shares, and if the stock goes up to infinity, you have to repay the loan with those infinitely valued shares! Most likely, you’re going to close out your position before that happens, but keep in mind that even if you close out your positions every night like a good day trader should, some strategies have the potential to cost you more money than you have in your trading account.

To protect themselves and to protect you against losing more money than you have, brokerage firms and options exchanges will require you to keep enough funds in your account to cover shortfalls. You will have to be approved before you can trade in certain securities. For example, anyone trading options has to fill out an agreement that the brokerage firm must first approve and then keep on file.

Playing the zero-sum game

Many day trading strategies are zero-sum games, meaning that for every winner on a trade, there is a loser. This is especially true in options markets. Now, the person on the other side of the trade might not mind being a loser; she may have entered into a trade to hedge (protect against a decline in) another investment and is happy to have a small loss instead of a much larger one.

The problem for you as a day trader is that there is little wiggle room in a zero-sum game. Every trade you make is going to win or lose, and your losses may exactly offset your winners. If your strategy takes place in a market that is a zero-sum game, such as the options market, make sure that you’ve tested your strategy thoroughly so that you know whether your odds are better than even.

Finding the probability of not getting the return you expect

In addition to absolute measures of risk and liability, there’s another consideration: volatility. That’s how much a security’s price might go up or down in a given time period.

The math for measuring volatility is based on standard deviation. A standard deviation calculation starts with the average return over a given time period. This is the expected return — the return that, on average, you’ll get if you stick with your trading strategy. But any given week, month, or year, the return might be very different from what you expect. The more likely you are to get what you expect, the less risk you take in the form of volatility.

Standard deviation shows up many times in trading, and there’s a detailed explanation of it. The key thing to know is this: The higher the standard deviation of the underlying securities, the more risk you take with your trade. However, the same volatility creates trading opportunities for day traders to exploit. A security with a low standard deviation isn’t going to offer you many chances to make money over the course of a day.

Standard deviation is used to calculate another statistic: beta. Beta tells you how risky a security is relative to the risk of the market itself. If you buy a stock with a beta of more than 1, then that stock is expected to go up in price by a larger percentage than the market when the market is up, and it’s expected to go down by a larger percentage than the market when the market is down.

High-beta stocks, and options on high-beta stocks, are riskier than low-beta stocks, but they offer a greater potential for return.

The word beta comes from the capital assets pricing model, an academic theory that says that the return on an investment is a function of the risk-free rate of return (discussed in the next section), the extra risk of investing in  the market as a whole, and then the volatility — beta — of the security relative to the market. Under the capital assets pricing model, there are no other sources of risk and return. Any other sources would be called alpha, but in theory, alpha doesn’t exist. Not everyone agrees with that, but the terms alpha and beta have stuck.

Getting rewarded for the risk you take

When you take risk, you expect to get a return. That’s fair enough, right? That return comes in a few different forms related to the risk taken. Although you might not really care how you get your return as long as you get it, thinking about the break-down of returns can help you think about your trading strategy and how it works for you.

Opportunity cost

The opportunity cost of your money is the return you could get doing something else. Is your choice day trading or staying at your current job? Your opportunity cost is your current salary and benefits. You’d give up that money if you quit to day trade. Is the opportunity cost low enough that it’s worth your while? It may be. Just because taking advantage of an opportunity carries a cost doesn’t mean that the opportunity isn’t worth it.

When you trade, you want to cover your opportunity cost. Your cost will be different than someone else’s, but if you know what it is up front, you’ll have a better idea of whether your return is worth your risk.

There’s another way to think about opportunity cost. When you make one trade, you give up the opportunity to use that money for another trade. That means you only want to trade if you know that the trade is going to work out, more likely than not. That’s why you need to plan your trades and backtest (run a simulation using your strategy and historic securities prices) and evaluate your performance so that you know that you are trading for the right reasons, and not just out of boredom.

Risk-free rate of return and the time value of money

The value of money changes over time. In most cases, this is because of inflation, which is the general increase in price levels in an economy. But it’s also because you give up the use of money for some period of time. That’s why any investment or trading opportunity should include compensation for the time value of your money.

In day trading, your return from time value is small, because you only hold positions for a short period of time and close them out overnight. Still, there’s some time component to the money you make. That smallest return is known as the risk-free rate of return. That’s what you demand for giving up the use of your money, even if you know with certainty that you’ll get your money back. In practice, investors think of the risk-free rate of return as the rate on U.S. government treasury bills, which are bonds that mature in less than one year. This rate is widely quoted in The Wall Street Journal and electronic price quote systems.

If you cannot generate a return that’s at least equal to the risk-free rate of return, you shouldn’t be trading.

Risk-return tradeoff

Economists say that there is no such thing as a free lunch. Whatever return you get, you get because you took some risk and gave up another opportunity for your time and money. In that sense, there is no secret to making money. It’s all about work and risk.

This is known as the risk-reward tradeoff. The greater the potential reward, the greater the amount of risk you’re expected to take, and thus the greater potential you have for loss. But if you understand the risks you are taking up front, you may well find that they are worth taking. That’s why you have to think about the risks and rewards up front.

The magic of market efficiency

The reason there’s a balance between risk and reward is that markets are reasonably efficient. This efficiency means that prices reflect all known information about the companies and the economy, and it means that all participants understand the relative tradeoffs available to them. Otherwise, you’d have opportunities to make a riskless profit, and that’s just won’t do according to the average economist. “You can’t pluck nickels out of thin air,” they like to say. In an efficient market, if there’s an opportunity to make money without risk, someone would have taken advantage of that already.

Here’s how it works: You have information that says that Company A is going to announce good earnings tomorrow, so you buy the stock. Your increased demand causes the price to go up, and pretty soon, the stock price is where it should be given that the company is doing well. The information advantage is rapidly eliminated. And in most cases, everyone gets the news — or hears the rumor — of the good earnings at the same time, so the price adjustment happens quickly.

Wouldn’t it be great if you could get the news of a good earnings report before everyone else, to make a quick trading profit? Yep. At least until the Feds show up and hauled you off to prison — talk about your opportunity costs. It is illegal to trade on material inside information (which would be information that is not generally known that would affect the price of the security). And yes, the Securities and Exchange Commission and the exchanges monitor trading to see whether trading patterns suggest illegal trading based on inside information, because they want all investors and traders to feel confident that the investment business is fair. Be very wary of tips that seem too good to be true.

Now, you’ll notice in the example that it was the activity of traders that caused the price of Company A stock to go up to reflect the expected good earnings report. The markets may be more or less efficient, but that doesn’t mean they work by magic. Price changes happen because people act on news, and those who act the fastest are day traders.

In economic terms, arbitrage is a riskless profit. A hard-core believer in academic theory would say that arbitrage opportunities don’t exist. In practice, though, they do. Here’s how it works: although Company A is expected to have a good earnings announcement tomorrow, you notice that the stock price has gone up faster than the price of a call option on Company A, even though premium should reflect the stock price. So, you sell Company A (borrowing shares and selling it short if you have to), and then use the proceeds to buy the option. When the option price goes up to reflect the stock price, you can sell it and lock in a riskless profit — at least, before your trading costs are considered.

Investing

Investing is the process of putting money at risk in order to get a return. It’s the raw material of capitalism. It’s the way that businesses get started, roads get built, and explorations get financed. It’s how our economy matches people who have too much money, at least during part of their lives, with people who need it in order to grow society’s capabilities.

Investing is heady stuff. And it’s very much focused on the long term. Good investors do a lot of research before committing their money, because they know that it will take a long time to see a payoff. That’s okay with them. Investors often invest in things that are out of favor, because they know that with time, others will recognize the value and respond in kind.

One of the best investors of all time is Warren Buffett, Chief Executive Officer of Berkshire Hathaway. His annual letters to shareholders offer great insight.

What’s the difference between investing and saving? When you save, you take no risk. Your compensation is low — it’s just enough to cover the time value of money. Generally, the return on savings equals inflation and no more. In fact, a lot of banks pay a lot less than the inflation rate on a federally insured savings account, meaning that you’re paying the bank to use your money.

In contrast to investing, day trading moves fast. Day traders react only to what’s on the screen. There’s no time to do research, and the market is always right when you are day trading. You don’t have two months or two years to wait for the fundamentals to work out and the rest of Wall Street to see how smart you were. You have today. And if you can’t live with that, you shouldn’t be day trading.

Trading

Trading is the act of buying and selling securities. All investors trade, because they need to buy and sell their investments. But to investors, trading is a rare transaction, and they get more value from finding a good opportunity, buying it cheap, and selling it at a much higher price sometime in the future. But traders are not investors.

Traders look to take advantage of short-term price discrepancies in the market. In general, they don’t take a lot of risk on each trade, so they don’t get a lot of return on each trade, either. Traders act quickly. They look at what the market is telling them and then respond. They know that many of their trades will not work out, but as long as more than half work, they’ll be okay. They don’t do a lot of in-depth research on the securities they trade, but they know the normal price and volume patterns well enough that they can recognize potential profit opportunities.

Trading keeps markets efficient, because it creates the short-term supply and demand that eliminates small price discrepancies. It also creates a lot of stress for traders, who must react in the here and now. Traders give up the luxury of time in exchange for a quick profit.

Speculation is related to trading, in that it often involves short-term transactions. Speculators take risks assuming a much greater return than might be expected, and a lot of what-ifs may have to be satisfied for the transaction to pay off. Many speculators hedge their risks with other securities, such as options or futures.

Gambling

A gambler puts up money in the hopes of a payoff if a random event occurs. The odds are always against the gambler and in favor of the house, but people like to gamble because they like to hope that if they hit it lucky, their return will be as large as their loss is likely.

Some gamblers believe that the odds can be beaten, but they are wrong. (Certain card games are more games of skill than gambling, assuming you can find a casino that will play under standard rules. Yeah, you can count cards when playing blackjack with your friends, but it’s a lot harder in a professionally run casino.) They get excited about the potential for a big win and get caught up in the glamour of the casino, and soon the odds go to work and drain away their stakes.

There is such a thing as a fair lottery, which takes place when the expected payoff is higher than the odds of playing. You won’t find it at most casinos, although sometimes the odds in a sports book or horse race favor the bettor, at least in the short term. A more common example takes place in lotteries when the jackpots roll over to astronomical amounts. For example, in March of 2007, the multi-state Mega Millions lottery had a jackpot of $370 million, but the odds of winning were 1 in 175 million. This means that a $1.00 ticket had an expected value of $2.11, making it a fair proposition.

Trading is not gambling, but traders who are not paying attention to their strategy and its performance can cross over into gambling. They can view the blips on their computer screen as a game. They can start making trades without any regard for the risk and return characteristics. They can start believing that how they do things affects the trade. And pretty soon, they are using the securities market as a giant casino, using trading techniques that have odds as bad as any slot machine.

Managing the Risks of Day Trading

Now that you know more about the risks, returns, and related activities of day trading, you can think more about how you’re going to run your day trading business. Before you flip through the book to find out how to get started, consider two more kinds for risk that you need to think about:
  •  Business risk
  •  Personal risk


Business risk

Business risk is the uncertainty of the timing of your cash flow. Not every month of trading is going to be great, but your bills will come due no matter what. You’ll have to pay for subscriptions while keeping the lights turned on and the computer connected to the Internet. Taxes come due four times a year, and keyboards hold a mysterious attraction for carbonated beverages, causing them to short out at the most inopportune times.

Regardless of what happens to your trading account, you need cash on hand to pay your bills or you’ll be out of business. The best way to protect yourself is to start out with a cash cushion just for covering your operating expenses. Keep it separate from your trading funds. Replenish it during good months.

Personal risk

The personal risk of trading is that it becomes an obsession that crowds out everything else in your life. Trading is a stressful business, and the difference between those who succeed and those who fail is psychological. And, in fact, the personal risk is so great that I devote an entire chapter to managing it.

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