THE OPTIONS COURSE- Mastering the Market

THE OPTIONS COURSE


Mastering the Market

Rising interest rates, comments from the Federal Reserve, and economic reports can all cause changes in the economic outlook, which can cause stock prices to move sharply higher or lower. When one examines the economic outlook in order to make investment decisions, it is known as a top-down approach to investing. Some traders prefer to take a bottom-up approach. In this case, you are more concerned about the individual investment. For example, you might start by studying an individual company and understand its detailsbefore making a decision.

We want to help you identify the fundamentals of profitable investment. You will have to decide, probably by trial and error, which of the many analytical techniques and market-forecasting methods work well for you. I find many investment tactics to be irrelevant to profit making, preferring to use strategies that are non directional in nature. However, there are a few basic guidelines that will enhance your ability to increase your account size consistently by making good investment selections.

DESIRABLE INVESTMENT CHARACTERISTICS

Finding promising trades is perhaps the most difficult issue to address when first starting out in the investment arena. While there are no absolutes, there are a few guidelines that will enhance your ability to identify profit-making opportunities. A desirable investment has the following characteristics:

• Involves low risk.
• Has a favorable risk profile.
• Offers high potential return.
• Meets your time requirements.
• Meets your risk tolerance level.
• Can be understood by you, the trader.
• Meets your investment criteria.
• Meets your investment capital constraints.

Involves Low Risk

First and foremost, a good investment must have low risk. What does low risk really mean? The term’s significance may vary with each person. You may be able to accept a risk level of $5,000 per trade based on the capital you have available. However, an elderly person on a fixed income may find $100 to be too much to risk. Acceptable risk is based on your available investment capital as well as your tolerance for uncertainty. You should trade only with money you can afford to lose, as there is risk of loss in all forms of trading.

Has a Favorable Risk Profile

Every time you contemplate placing a trade, you need to create a corresponding risk profile. Whether you trade shares or commodities, invest in real estate, or put your money in the bank, every investment has a certain potential risk/reward profile. Some are more favorable than others. Studying a risk profile can show you the potential increasing or decreasing profit and loss of a trade relative to the underlying asset’s price over a specific period of time. As the variables change, the risk curve changes accordingly.

In order to find the best investment, you have to look for trades that offer optimal risk-to-reward ratios. For example, which of the following investment choices has the better risk-to-reward ratio?

• Trade A: potential risk of $1,000; potential reward of $1,000.
• Trade B: potential risk of $1,000; potential reward of $5,000.

Anyone would rather make $5,000 than $1,000. However, to actually make a good decision, you must also have enough knowledge to discern which trade has the greater probability of working out. Another key ingredient is time frame—the time it takes to make the money. If trade A can make me $1,000 in one month with a 75 percent chance of winning, and trade B takes a year to make $5,000 with a 75 percent chance of winning, I would rather go with trade A. In one year, I could potentially make $9,000 [(12 × 1,000) × .75] repeating trade A, and only $3,750 ($5,000 × .75) using trade B. This is referred to as an expected value calculation.

The risk/reward profile of any investment must take into account the following elements:

• Potential risk.
• Potential reward.
• Probability of success.
• How long the investment takes to make a return.

Offers High Potential Return

Risk comes hand-in-hand with reward. A trader cannot be expected to take a risk unless reward is also in the equation. Believe it or not, I have seen countless investors make foolish investments where the risk out-weighs the reward many times over. Why would they do such a thing? Usually because they simply haven’t taken the time to verify the potential risk and reward of the trade or they are taking advice from someone who doesn’t know any better.

The best investments have an opportunity for high reward with acceptable risk. In addition, the good trades have a high probability of winning on a consistent basis. I consider 75 percent an acceptable winning percentage. This means I win three out of four times I place a trade. A baseball player who could do this would have a .750 batting average— which is unprecedented in baseball history.

Meets Your Time Requirements

The process of locating and monitoring your investments must meet your time constraints if you are to be successful. In other words, if you do not have the time to sit in front of a computer day in and day out, then your best investments will not be day trades (entering and exiting a position in the same day). If you don’t even have the time or inclination to look at your investments over a one-week period, then you have to take this into consideration. The time you have available for making investment decisions and monitoring those investments will affect the types of investments you should make. If you don’t have enough time to pay attention to a trade that needs to be closely monitored, chances are you’ll lose money on it. The best investments will match your time availability.

Meets Your Risk Tolerance Level

Your risk tolerance level is directly proportional to your available investment capital. Risking more than you can afford to lose creates stress that impairs your ability to make clear decisions. Some people have the ability to handle uncertainty better than others. It is important to accurately assess your own risk tolerance levels and stay within those boundaries as you progress up your own trading learning curve. As experience in the markets naturally develops your confidence level, your risk tolerance level will increase.

Can Be Understood by You, the Trader

One of my most basic investment rules is as follows: If you don’t know how hot the fire is, don’t stick your hand into it. This rule is broken on a consistent basis by many beginning and intermediate traders. In addition, many seasoned traders singe their fingers as well. Basically, if you don’t understand the exact characteristics of a trade, it is better to walk away from it. It is imperative that you familiarize yourself with the trades you place. Each trade has a unique personality. Your personality and your trade’s personality have to match for you to be successful over the long run.

Meets Your Investment Criteria

Your personal investment criteria can come in many shapes and sizes. Each individual has personal goals, expectations, and objectives when making investments. When I ask my students what they want out of their investments, the typical response is to make money. However, there are a number of related issues that also must be evaluated, including:

1. Capital gains (stocks—medium- to high-risk securities). What are the tax implications of your investing and trading practices?
2. Interest income (fixed income securities—medium-risk bonds and lowest-risk U.S. government securities). Is your objective to earn interest income?
3. Security (government securities—lowest-risk securities). Do you want to invest in only low-interest, low-return investments such as U.S. government securities (e.g., Treasury bonds)?

Meets Your Investment Capital Constraints

Do the investment requirements match your capital available for investment? Just as your investment strategy must meet your personality and time constraints, the capital you have available will have a major impact on what you invest in, how often you invest, and the number of contracts you can afford to trade. For example, if you have a small account (less than $10,000), you will invest very differently from someone with $1 million. In addition, if you’re trading commodities with a small account, you should trade in markets that have low margin requirements and good return potential. 

You should stay away from the high-margin markets such as the S&P 500 stock index futures. No matter how much money you have to invest, start small. I have taught a variety of people over the years with a very wide range of capital available for investment. I advise them all to start by trading small until they figure out what they’re doing. Whether you have $1,000 or $1 million, you have to learn to walk before you can run. In the beginning, I recommend risking only 5 percent of your account on any one trade. In this way, you can afford to learn from your mistakes as a novice trader.

Often, having too much money as a beginner can be detrimental. The more money you have, the greater the chance of overinvesting and making costly mistakes. I find that the best long-term investors are very cautious early on. However, they systematically increase the size of their trades based on the steady increase in capital in their accounts. For example, you may begin with $5,000 and choose to invest 100 shares at a time, then not increase to 200 shares until such time as your account has doubled to $10,000.

IMPORTANCE OF TARGETED EXIT POINTS

One of the most important decisions a trader must make when entering a position is determining when to sell or close out the trade. It is imperative to set a target exit point for each trade. A target exit point is an option price that would result in a substantial, yet attainable, profit. By setting your profit objectives in advance and determining your target exit point before you trade or at the time you make your option purchase, you avoid the consequences of one of the major stumbling blocks to achieving trading profits: greed. It is very hard for most investors to set reasonable profit goals once an option has jumped substantially in price. 

That extra point becomes a moving target with each advance in the option’s price. Therefore, it is not surprising that a reasonable profit is not achieved when the investor is forced to bail out because of tumbling prices. Although setting profit goals in advance may be simplistic and not the most flexible approach to option trading, the target exit point approach to taking profits is a necessary compromise. This is especially true for the options trader who has neither the savvy nor the emotional control to know when to hold and when to fold in the heat of battle, and who is also unable to stay tuned to the markets throughout the trading day.

Note also that the profit objective should be substantial, meaning at least 100 percent, or double your initial investment, so you will not be walking away with small profits by using this approach. With this approach, you will miss out on those 1,000 percent gains that are the options equivalent of hitting the jackpot; but much more important, you will minimize the instances of solid profits becoming painful losses and you will regularly be taking respectable gains off the table. Once you have entered the heat of battle, the tendency will be to base your decisions upon emotion, and therefore your decisions will tend to be incorrect. To avoid this pitfall, set a closeout date based on the amount of time you expect the option needs to reach its target exit point. 

If that profit level has not been reached by the closeout date, exit the position on that date. Closeout dates should be set so that there is still enough time until expiration to salvage some time value from the option if the underlying stock has failed to move. Resist the temptation to sell at a small loss prior to your closeout date. You will be yielding to fear, robbing yourself of some potential gains. Also, resist the temptation to raise your profit objective as the price of the option nears your target exit point. You will then be yielding to greed, and your profits will slip away. Another important question that needs to be addressed is when should you not sell? You should not sell a position the instant it moves against you. 

There is never a need to engage in panic selling if it is assumed that your original conditions for opening the position still hold true (e.g., your market outlook and your outlook for the stock on which you own options have not changed); also, that you are not committing an excess amount of trading capital and you are still operating within your own risk tolerance. As option traders we create option positions for their huge profit potential, which can be fully realized only by allowing positions to remain open for a reasonable period of time. Setting predefined exit points goes a long way to facilitate this task.

TIPS FOR SPOTTING AN EMERGING BULL MARKET

Although no two bulls or bears are exactly alike, and sometimes their signals may be a bit obscure, eventually the indicators will pile up and a trend will become evident. As you analyze the stock market for signs of shifting trends, be cautious. Each market is different from its previous cousins, so not all the warning signs will be present each time. If you notice only one or two of the telltale clues, some fleeting business or economic event temporarily may be tilting the market. However, if you detect four, five, or more of these signs appearing all at once, you’ve probably discovered a major new market phase.

Before the bull begins to charge ahead, you will find six major signs that the bear has retreated into hibernation. Most of these signs apply to stocks, but often they readily relate to other investment markets as well. One of the signs is that the market has undergone a mature decline. Naturally, if you want to determine whether a new market is on its way up, one of the first things you’ll do is determine what activity has come before. If the market has undergone a mature decline then a bull may not be far off. Second, look for a market that is dull and boring. 

Historically, bear markets generally storm onto the market scene, but they depart extremely quietly. This kind of lackluster activity is one of the most common signs that a bear market is losing strength. Such sluggishness may go on for weeks or even months, but stock prices do not necessarily tumble along with trading volumes. When this scenario occurs, professional investors might say the market has been seized by a complacent attitude. The next possible sign is when the market resists bad news. Generally, financial and even some sociopolitical news has a marked effect on the markets. When the markets refuse to budge, despite significant developments, you definitely should take notice. 

Another sign is when the gloom is so deep that even the top-quality investments are sold. As a severe bear market grinds on for what seems like forever, stock investors, for example, often sell their blue-chip securities in one last brief selling period. These probably are the last stocks to go, as investors will have unloaded their lower-quality holdings at the start of the bear. When the market has fallen to an uncomfortable degree, and investors believe hope for a quick recovery is gone, blue chips hit the market with a sudden decline. Not surprisingly, that tends to reinforce the bleak market mood, as investors begin to think that if even the best stocks are acting this way, then something really must be wrong with the market.

Next, as a bear market begins to fade, stocks that once sold at price-earnings ratios of, say, 18 to 20 times earnings often are selling at unusually low P/Es, perhaps less than half their former figures. When those stocks once regarded as must-have securities lose all their appeal, the change from the normal situation should cause investors to take notice. Those who have a chance to purchase bargain stocks before the next bull market should swing into gear. Finally, high dividend yields offer a key signal. Like low price-earnings ratios, the often high-dividend yields to be found at the tail end of a bear market represent a market reversal in market psychology. 

Although yields in a bear market typically are higher than those for the same stock at the peak of a bull market, you can look for this phenomenon to alert you that a bear market has run its course. What does it mean when you can identify several of these indicators? Obviously, the bear market has begun to fade and the bull market slowly is taking shape. More and more trading occurs daily, and the number of advances, the upward movements in the prices of the individual investments, outpace the declines. The volume of trading and the number of advances and declines indicates the market breadth. To summarize, be aware of the following key signals that a bear market is approaching a bottom. 

First, market prices have been declining for more than 12 months. Second, the volume of trading declines and you start to observe a very boring market. Third, bad news makes no impression on the markets. Fourth, investors start unloading top-quality investments by heavily selling many of the blue chips. Fifth, investments that once were stars are now on the skids, selling at undervalued prices. With stocks, price-earnings ratios are unusually low. And finally, sixth, stock dividend yields rise abruptly. The bottom line is if you observe most or all of these signs, the bear market is probably coming to an end and a new bull may not be far behind.

TAKE A LOOK BEHIND THE ANALYST CURTAIN

How many times have you placed a trade that you thought was perfectly set up only to have an unforeseen or unexpected event cause the trade to go bad? The technicals all looked good; maybe even the fundamentals were all in place. To all intents and purposes, the trade looked like a winner. Then all of a sudden out of nowhere comes a comment from one of the “guru goons” (my term for analysts), the company announces an acquisition that the Street doesn’t like, or maybe even a bizarre incident like an earthquake in Taiwan! The underlying then reverses and the trade moves against you. Let’s look behind the scenes of how analysts and institutions really work.

It’s amazing how many individual investors and traders still live and die by analysts’ recommendations. Many people actually still think that analysts make recommendations for the good of investors. Think about it, who do the analysts work for? They work for the institutions. Why do analysts continue to rate a stock a “strong buy” while the underlying is bleeding a slow death? Why do the same analysts raise a stock’s rating that has clearly been in an extended uptrend? Institutions build inventories in stocks that they then allocate to their brokers to sell to investors. In some cases, it is nothing more than a quota that the broker is expected to sell. The analyst from the institution will then focus on some piece of positive data regarding the stock and raise the ratings on the same. 

This causes a short-term buying interest in the stock by retail investors and usually a bump up in the price as well. Who are the retail investors buying from? Their institution! The institution has been accumulating inventory in a stock, so then it manufactures a buying spurt and depletes its inventory at a higher price. Many times this occurs as the stock is showing signs of topping out. The institution makes money, and who is left holding the “bag” or stock? Institutions are in the business to make money, and that consists of more than just broker commissions. If the investors make money, then that’s okay, too, but it’s not the priority. In fact, in some cases your own institution will actually take a position against your trade! It goes even deeper. 

If an institution is dumping an inventory and you have purchased the stock and later decide that you want to sell, the institution won’t buy your stock back! It will execute your trade only after it finds some other patsy to take it off your hands. Have you ever wondered why analysts always seem to be a step behind? When a company announces something negative, if it’s a stock that the institutions are interested in, the analysts all jump on the bandwagon with downgrades. As retail investors are dumping the stock based on the downgrades, the institutions are sitting back and waiting for the downdraft to subside and then they begin to start accumulating again. The whole process starts all over again. How about raising a stock to a “strong buy” once it appears ready to break out of a long-term consolidation or basing pattern? Wouldn’t that be a novel idea? That would mean that analysts were really employed to help investors, however. 

Then there are all of the amazing abuses of investors by analysts regarding initial public offerings (IPOs). How many investors own Internet stocks that were priced at ridiculous price multiples due to continued upgrades by analysts as the stock prices went into the stratosphere? How many investors still own those stocks today under $10 a share? Do you think the institutions feel bad that they sold investors those stocks at ridiculous multiples? Believe me, they will only feel bad until they look at their bottom lines. Some of these longtime abuses are finally beginning to surface in the media, both on the television networks as well as in the print media. Some investors have even sued the analysts. 

Okay, so what’s my point in all this? We are on our own out here and have only ourselves to hold accountable when investing our hard-earned money. Optionetics exists because no matter how much research we do, no matter how good a trade looks when we place it, things happen that are out of our control and can cause trades to go against us. Hedging all trades is crucial. When an unforeseen event does happen, we can employ a creative options strategy to take advantage of it. Even in our worst-case scenarios, our losses are minimal and we live to fight another day. Option strategies are designed not only to aid your research, but also to help hedge the trades you make, regardless of existing market conditions or directional bias.

COMPUTERIZED TRADING SYSTEMS

Trading systems facilitate trader discipline. Computerized systems offer additional advantages. The speed and efficiency with which a computer identifies patterns and generates signals is one obvious advantage. Computers can quickly achieve the number crunching necessary to recognize trading signals. However, it is possible for a trader to calculate these signals manually (in the time required), and the trader’s ability to evaluate a complete rule-based system is limited as well. Computer systems offer direction and suggestions about what to do in a given market and help limit the range of choices. This makes the trader’s task less overwhelming, because the possibilities and opportunities become more clearly defined.

Trading systems approach the market consistently and objectively. Programs are designed logically. Rules are uniformly applied to defined market conditions. Trading systems are effective since rules are not the victims of trader judgment. The whimsical nature of a trader is diminished by a system. The emotional aspect of trading can be significantly reduced as well since systems are void of emotion and judgment. Unfortunately, the emotional tendency of a trader is to outguess the system, even when it’s producing profitable trades. If a trader can discipline himself or herself to follow a system with rigor, emotions will not rule the decision-making process. Trading systems are designed to think, not to feel. 

Another positive feature of trading systems is that they generally include money management rules that help to facilitate trading discipline. One of the more common arguments against trading systems is that they can become popular enough to influence the underlying price. This concern has been voiced both by the market federal regulatory agencies and by individual traders. The concern is that the similarity of computer-based systems used to manage large positions may cause large traders to respond in the same way at the same time, thereby causing distortion in the markets. While it is not guaranteed that past price patterns guarantee future price patterns, it is also not true that markets are random. 

Another argument against the use of trading systems is they define market behavior in limited ways when the market can, in fact, behave in an infinite number of ways. It is believed that because systems are mathematically or mechanically defined, this reduces relationships of events to percentage odds of what could happen next. While the criticism is valid in that systems do capture a very limited number of possibilities, this characteristic is also what makes systems useful. The ability to reduce information to observable patterns gives the trader some semblance of order and direction. Without this, many traders feel overwhelmed and directionless.

One of the more controversial techniques to develop from computerized trading is the concept of optimization. Optimization is a process by which data is repeatedly tested to find the best results. The best moving average size, point and figure method, or other parameters are made to fit the raw data. It is important to understand the methods of optimization and to provide proper precautions regarding optimized trading systems. Performed properly, extensive testing can reveal a great deal. However, excessive optimizing can be misleading, deceptive, and costly. Trading systems give the trader a way to interpret, quantify, and classify market behavior. 

Since trading systems define potential opportunity and provide specific trading signals, following these signals can facilitate the development of profit-making trading skills as well as strong exit and entrance discipline. Computerized trading systems have vastly expanded the scope of information available to today’s traders. Systems can now be thoroughly back-tested and perfected using the computer to test many if-then scenarios. Trading systems offer a way to define and categorize market behavior by reducing information to patterns that generate trading signals. While systems are without emotion, traders are not and often try to outguess a system. Misuse and lack of discipline are major causes of losses in trading systems.

CONCLUSION

The investment elements are designed to guide you on the road to trading success. Trading can be a humbling experience. It can also be highly profitable. Perhaps it is human nature to get a little overconfident and cocky when the money starts rolling in. But that’s the time when you need to fight against your own bravado. Remember, it takes only one big mistake to send you back to ground zero. Start small and let your account grow consistently. There’s always more to be learned and a better trade down the road.

In addition, there a number of things you can do to protect your account. Use the following six guidelines to safeguard your share of market profits:

1. Do your own research before you invest. Don’t invest in companies that minimize or avoid disclosure of their financial condition. Always read the fine print in your information sources and avoid hot tips.
2. Deal with major brokerage firms and reputable brokers. Know your brokerage firm’s financial condition and who owns the firm. Be sure you know what your agreement specifies.
3. Keep a written record of all trades. Write your orders in advance. When you receive trading confirmations, make sure to compare them with your written records.
4. Put your broker to work. If trading confirmations are slow in coming, complain to your broker. Balance all monthly statements. Ask your broker to explain any discrepancies. If trouble persists, go to a supervisor. If it continues, change firms.
5. Change brokers who talk about sure winners. Resist all sales manipulation emphasizing double-digit rates of return, shares that will double, hot stocks, and guaranteed profits.
6. Never put greed before safety. Sometimes you have to protect yourself against yourself, and that can be the most difficult job of all. Remember the market will be here tomorrow—but to use it, you need investment capital.

Hopefully, this information will help you avoid or deal effectively with many of the issues that you might experience. Investors who know how to choose a good broker, how to analyze information, how to order skillfully, and how to protect themselves are investors who know how to make money.

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THE OPTIONS COURSE- SECURITIES AND EXCHANGE COMMISSION

THE OPTIONS COURSE


SECURITIES AND EXCHANGE COMMISSION

In the United States, stock exchanges are regulated by the Securities and Exchange Commission (SEC), which was created by Congress in 1934 during the Depression. It is composed of five commissioners appointed by the President of the United States and approved by the Senate and a team of lawyers, investigators, and accountants. The SEC is charged with making sure that security markets operate fairly and with protecting investors. Among other acts, they enforce the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.

The SEC is also in charge of monitoring insider trading as well as detecting corporate fraud. Insider trading is a form of trading in which corporate officers buy and sell shares within their own companies. This type of trading is widely influenced by inside information that only corporate officers have access to. Many off-floor traders keep track of insider trading to gauge the movement of a specific stock. In addition, there are a multitude of regulations aimed at preventing corporate officers from profiting from information not released to the general public during mergers or takeovers.

Corporate Fraud

Corporate fraud has been in the news a great deal in the United States since the accounting scandals of 2002 rocked Wall Street and the U.S. economy. The collapse of Enron, the bankruptcy of WorldCom, and a series of lawsuits against high-profile executives, including Martha Stewart, give the impression that global corporate fraud and misconduct are rampant. This, of course, occurred during the second year of a bear market— a period that saw some stocks lose 50, 60, and sometimes 70 percent or more of their values, Since stocks were already reeling, the exact impact on the stock market as a whole is difficult to determine. Therefore, the exact impact of the corporate misconduct remains difficult to quantify.

While the exact impact of accounting scandals and corporate fraud is difficult to measure, without question the fact remains: The Enron debacle and subsequent bankruptcies have eroded investor confidence in U.S. financial markets. They also dealt a financial blow to the shareholders of bankrupt companies like WorldCom, Enron, and Adelphia Communications. On a national level, the scandals and fraud left many investors wondering, who is next? When will the next shoe drop? Those concerns served to keep many investors away from stocks. Unfortunately, there is little hope for a market rebound during an absence of prospective buyers. Eventually, some of the concern faded. 

On February 11, 2003, Federal Reserve Chairman Alan Greenspan said that he believed that the corporate scandals that shook Wall Street in the summer of 2002 were reaching an end. “I would be very surprised if it were initiated beyond mid-2003,” the Fed chairman said in a speech to the Senate Banking Committee. “It is not a problem for the immediate future.” One reason for his optimism stemmed from the passage of the Sarbanes-Oxley legislation approved by Congress in 2002. The new law restored some of the lost investor confidence. Yet investor confidence can prove fragile. While it is hard to tell just what impact corporate scandals had on the stock market, it is clear that investors have begun to recognize it as an additional risk. 

As time passed, some of the fears and uncertainty began to fade. Stricter regulation and greater enforcement by the Securities and Exchange Commission have played important roles in shoring up investor confidence in financial markets. Still, believing that every issue related to corporate malfeasance and accounting scandal has been solved would be naive. In fact, such problems might resurface at any time and rekindle investor jitters. If and when this scenario will play out again is unpredictable. Nevertheless, corporate misconduct is an important factor to consider before stepping into the financial world. Make sure that all your trades consider the possibility that such problems could resurface anytime in the not too distant future. Manage your risk!

INFLATION CATEGORIES AND GOVERNMENT IMPACT

Economists recognize two principal types of inflation: cost-push inflation, in which increases in the cost of raw materials and/or labor are reflected in higher prices, and demand-pull inflation, which is caused by the demand for goods increasing faster than the supply. Cost-push inflation usually results from a chain of related events. For example, if the labor costs involved in producing a specific raw material rise, the supplier of that material will pass on the increase to the manufacturer who uses the material in a finished product. The manufacturer, in turn, raises prices on the finished product in order to protect their profit margin.

The consumer who buys the product ultimately pays for the higher cost of labor in the price of the product. When this happens in several industries at once, consumers who are also workers demand higher wages to help meet the increased prices. This, in turn, sets off another round of price increases as manufacturers and retailers attempt to recoup their higher labor costs. As the cycle continues, it raises the cost of living for everyone. Demand-pull inflation, in contrast, is caused by increased demand for a product or material, or by scarcity of that commodity. During the 1970s, many of the world’s oil-producing nations held their product back from the market at a time when demand for petroleum was increasing rapidly.

The results were across-the-board increases in the prices of oil, gasoline, and synthetic materials made from petroleum. In turn, refiners, power generating companies, and manufacturers passed along the higher prices of crude oil to consumers. In addition, the fuel costs of freight haulers who delivered goods rose, and these, too, were passed on to consumers. In some instances, demand for goods is stimulated by the availability of extra dollars. The amount of money in circulation increases faster than productivity in the economy, leading to greater demand. In effect, money chases supply. 

For example, during the 1960s, the government increased the amount of money in the economy rather than raising taxes to pay for the war in Vietnam. The resulting inflation was, in effect, a hidden tax to pay for government operations, because wage earners were pushed into higher tax brackets. The federal government can impact inflation and the overall economy in three major ways. First, the government can spend more money than it collects in taxes, duties, and fees. Such deficit spending tends to stimulate the economy. But the government must borrow the difference between its income and expenditures, usually by selling Treasury bonds or bills.

When the government enters the credit markets, it competes with other big borrowers, such as corporations, for the dollars that are available. The resulting increase in demand for money tends to raise the interest rate. Rising interest rates reduce the overall demand for many goods and services, particularly those that are financed, such as housing, durable goods, and plant and equipment. Thus, initially deficit spending tends to increase overall demand, while borrowing to finance the deficit tends eventually to decrease such demand. The net inflationary impact depends on the state of the economy and the relative effects of these two forces.

If the economy has slack in it, additional stimulation has little or no inflationary impact. If the economy is already booming, further stimulation can push up prices dramatically. The relative effect of the deficit depends on how it is financed. This always prompts an economic debate on how best to impact our economy: balanced budgets versus deficit financing. The second way in which government can affect the economy is through its taxing policies. By raising taxes, government can slow the rate of growth in the economy. By reducing taxes, it can provide more money for economic growth. Over the years, the Congress has tended to use this technique to stimulate specific areas of the economy.

For example, the deduction for mortgage interest payments on personal residences was designed to boost the home-building industry and the many other industries it influences. The investment tax credit, which was repealed in 1986, was instituted to encourage businesses to expand their plants and buy new equipment. Other tax measures have targeted areas in similar ways. Finally, the third major government influence on inflation and the economy is the Federal Reserve. One of its jobs is to regulate the supply of money in the economy. If the money supply grows too quickly, prices will rise faster than productivity, which fuels inflationary pressures. If the Federal Reserve tightens up on the money supply too much, it could throttle a growing economy.

Despite the fact that the Federal Reserve is a government-chartered corporation, it is not required to work with other branches of the government to coordinate action affecting the economy. However, the Federal Reserve is required to report to Congress, and Congress can change the laws affecting it. In addition, the President appoints its membership. In some cases, actions by the Federal Reserve may be opposite those of the Administration and Congress, causing mixed economic results. Regardless of the current political environment a savvy investor must be keenly aware of the current inflation trend and the impact it has on the investor’s savings, income, and portfolio. This understanding can make a major difference in an investor’s financial future.

FED FUNDS FUTURES CONTRACT AND MONETARY POLICY

The federal funds rate is the interest rate banks pay when they borrow Federal Reserve deposits from other banks, usually overnight. It is closely watched in financial markets because the level of the funds rate can be immediately and purposefully affected by Federal Reserve open market operations. The Federal Open Market Committee, the main policy-making arm of the Federal Reserve, communicates an objective for the fed funds rate in a directive to the trading desk at the Federal Reserve Bank of New York. Actions taken to change an intended level of the fed funds rate are motivated by a desire to accomplish ultimate policy objectives, especially price stability. 

Permanent changes in the fed funds rate level are thus the consequence of deliberate policy decisions. The fed funds contract, also known as 30-day fed funds futures, calls for delivery of interest paid on a principal amount of $5 million in overnight fed funds. In practice, the total interest is not really paid, but is cash-settled daily. This means that payments are made whenever the futures contract settlement price changes. The futures settlement price is calculated as 100 minus the monthly arithmetic average of the daily effective fed funds rate that the Federal Reserve Bank trading desk reports for each day of the contract month. Payments are made through margin accounts that sellers and holders have with their brokers. 

At the end of the trading day, sellers’ and holders’ accounts are debited or credited to facilitate payments. Fed funds futures are a convenient tool for hedging against future interest-rate changes. To illustrate, consider a regional bank that consistently buys $100 million in fed funds. Suppose the bank’s analysts believe that economic data to be released in the upcoming week will induce the FOMC to increase the objective of the fed funds rate by 50 basis points at its next meeting. If the contract settle price (for the meeting month) implies no change from the current rate, the bank may choose to lock in its current cost by selling 20 contracts (or taking a short position) and holding the position to expiration. 

Conversely, suppose that a net lender of funds expects a policy action to lower the fed funds rate. It can protect its return by purchasing futures contracts (or taking a long position). Participants in the fed funds futures market need not be banks that borrow in the fed funds market. Anyone who can satisfy margin requirements may participate. Thus, traders who make their living as “Fed watchers” may speculate with fed funds futures. This would suggest that to the extent Fed policy is predictable, speculators would drive futures prices to embody expectations of future policy actions. Since the level of the fed funds rate is essentially determined by deliberative policy decisions, the fed funds futures rate should have predictable value for the size and timing of future policy actions.

Given that the trading desk may face systematic problems that hinder its ability to achieve its objective, the consequences for the funds rate may be predictable. Speculators who anticipate such effects may find it profitable to buy or sell current contracts. In the case of fed funds, the rate is essentially determined by a deliberative decision of the FOMC, the main policy-making arm of the Federal Reserve System. Hence, the fed funds futures markets must anticipate actions taken by the FOMC. In short, through the fed funds futures markets, one can place a bet on what future monetary policy will be. The committee then can get a clear reading of what these market participants expect them to do, which may at times be helpful for FOMC members who place great weight on knowing if a policy choice would surprise the market.

If they are to be instructive for policymakers, the fed funds rate should have some predictive content. The predictive accuracy of futures rates historically improves over the two-month period leading up to the contract’s expiration, providing some evidence that the market is efficient in incorporating new information into its pricing. The largest prediction errors have occurred around policy turning points. Nevertheless, there is considerable evidence to suggest that the fed funds futures markets are efficient processors of information concerning the future path of the fed funds rate.

U.S. DOLLAR’S IMPACT ON GLOBAL COMMERCE

The rate of economic growth—meaning the rate of gross national product (GNP) growth—is determined by three key rates: the interest rate, the tax rate, and exchange rates. The business cycle is influenced by those rates, which in turn are shaped by monetary, fiscal, and trade policy. Given the global economic environment that we live in, it’s important to understand world trade basics and how the dollar actually impacts global commerce. Assume that you buy a Japanese-made car. The dealer who imported the car has to pay an exporter in Japan for the cost of the vehicle that’s been sent over. 

The exporter wants to be paid in yen, the Japanese currency. So the importer takes his dollars and buys yen from a currency dealer or bank. The number of dollars he pays for the amount of yen he gets is determined by the exchange rate. He then sends the yen to the exporter in Japan and sells you the car he’s purchased. The same thing happens in reverse when a Japanese consumer buys an American-made product. A U.S. export turns into a Japanese import just the way a Japanese export becomes a U.S. import. All things being equal, if imports and exports occur in the same total amount, the balance of trade will be equal. 

Simply put, if the balance of trade between two countries is equal, then the rate of exchange between the currencies of those two countries will also be equal. That may be hard to grasp, because many investors think that currency has intrinsic value. But currency is only worth what it will buy. Ask yourself how much value a U.S. dollar has in a land where goods are bought and sold in yen. If the Japanese have no U.S. imports, they’ll need no dollars, and the dollar will be nothing more than a souvenir. The same is true of the yen’s value in the reverse situation. In Houston, where goods are paid for in dollars, a yen is worthless unless it’s needed to pay for a Japanese import. 

And if you need it because you’re taking a trip to Japan, that’s also counted as an import. When Americans spend abroad, they have the same effect on the balance of trade as an importer. In both cases, yen must be bought, and dollars flow out. But if no trade takes place, there is no need for currency exchange. When it does take place, if the Japanese need as many dollars as Americans need yen, the dollar and the yen will be equal in value. That’s how the dollar shapes up when all things are equal. But things are never equal, and that means you’ve got to think about the shape the dollar’s in when you’re trying to stay ahead of economic trends. 

The problem is that the United States is now the world’s largest debtor nation. If we exported more than we imported, our trade account would have a surplus. But because we import much more than we export, we now have a hefty yearly trade deficit. The more we import, the more foreign currency we have to buy to pay for it. Since we need more foreign currency and our trading partners need fewer dollars because they have fewer U.S. imports to pay for, demand for dollars is less than demand for yen and German marks, for example. That means a strong yen, or mark, and a weak dollar. Trade imbalance normally works itself out. 

As we import more and more Japanese goods, the dollar will weaken against the yen. That will make Japanese goods more expensive, which will reduce our imports of them. On the other side, a weakening dollar makes our exports less expensive. So the Japanese should buy more of them. As they import more and we import less, trade will eventually balance. The difficulty is that countries erect barriers to trade, and these barriers act to strengthen or weaken currency, which in turn affects economic growth. The U.S. can regulate the strength of the dollar in several ways. On the fiscal side it can enact protectionist legislation and impose traffic and import quotas on foreign goods. 

Or it can push for international trade agreements, which require its partners to export less and import more. The United States can also adjust exchange rates by using monetary policy. If the dollar is falling or rising sharply, the Fed, acting with foreign central banks, can buy or sell dollars in the currency markets. This is known as intervention to either support or weaken the dollar, a result that can be achieved in the short run only. In the long run, no amount of intervention can overcome the balance of trade when it comes to determining the dollar’s exchange value. Hopefully, this discussion has given you a greater appreciation of the intimate nature of the U.S. dollar and world trade.

CONCLUSION

Many traders ignore the macro-type analysis for the stock market that can be put together using various forms of economic and bond data. This big picture provides the trader and investor alike a very important starting point before they hone in on potential trading opportunities. There is an abundance of economic data that has an inextricable linkage to the stock market. For instance, when bond prices drop too much, forcing yields higher, this often has a devastating impact on the stock market. In general, bond yields have more of an effect on the financial sector versus other sectors such as the food service stocks, for example. 

To this point you will see that when there is overall strength in the financial stocks, bond yields will drop. Keep in mind that many times declining long-term interest rates fuel a stock market rally and this is why when stocks are not focusing on quarterly earnings they focus on bond yields. If bond yields reach too high a level, companies may have to start paying more to borrow money, which adversely impacts profits. Of course, declining profits in turn lead to declining stock prices. To overcome rising bond yields, earnings have to come in better than expected to see appreciation in the stock price. Another trend to watch closely is when investors leave stocks to go into bonds, making it difficult for companies to raise money. 

This also indicates what is known as a “flight to quality” where investors decrease the money flow into stocks to pursue safer investments. Due to its adverse impact on corporate profits, inflation is another key factor that needs to be monitored. For example, the prices-paid element of the Institute of Supply Management report gauges inflation. If prices-paid come in too strong, not only will bonds sell off, but stocks will sell off as well. For these same reasons the Consumer Price Index, which measures prices on consumer goods and services, and the Producer Price Index, which calibrates prices on various goods such as commodities, capital items, automobiles, and textiles, should also be watched closely for inflationary pressures.

Another report that can impact the inflationary outlook is the retail sales report. If this report, for example, experiences an upward revision from the previous month this can cause both the stock and bond market to sell off. Basically, these four inflation-type reports impact both the stock market and the bond market in the same way. The bottom line here is that the primary stock market catalyst is corporate profits. A major factor for profitability is having an economy that shows low inflation. Overall, if the economic reports are coming in strong, the bond market will begin to be concerned about the Fed increasing interest rates to derail possible inflation. 

This will in turn cause bond yields to rise and foster an environment where stocks are more than likely going to decline because of the increased competition among the investment community on where to get the best return. Another major reason you should track these reports is that just like corporate earnings, economic reports and Federal Reserve decisions also come with their own expectations. For example, if the stock market is anticipating a raise in rates by the Federal Reserve and it doesn’t happen, then expect the stocks to decline across the board because stocks will reprice themselves to reflect the higher rates. These higher rates dampen both business and consumer spending due to the fact that borrowing costs are now higher. 

The higher rates can sometimes actually spur a recession and can reduce inflation with interest rate–sensitive stocks being the beneficiary. Now of course, when the Federal Reserve cuts rates this can have a very positive impact on both the stock and bond market. Also, if rates are unchanged then more often than not this generates a positive signal to the equities market. In this same vein, there is always a concern that the Fed can reduce interest rates too much, pumping too much money into our economic system, which can fuel stock prices, resulting in asset inflation. Another more cryptic thing to monitor is certain chatter that occasionally comes out of the Federal Reserve. 

For instance, a news story about a key Federal Reserve official warning about possible inflation or Alan Greenspan talking about overvalued assets could ignite a stock market sell-off. The point I want to leave you with is that this type of macroanalysis of the economic environment is an essential starting point when developing a general bullish or bearish scenario. This analytical backdrop has always given me the extra confidence I needed to pull the trigger based on Elliott wave, MACD, or any other technical tool I choose to employ before making a trading decision based on a directional bias.

Additionally, paying close attention to interest rates can help you to forecast market direction. Although many delta neutral strategies are not dependent on market direction, it never hurts to be able to anticipate movement. Since prices have extremely erratic fluctuation patterns, monitoring interest rates is a relatively consistent method that can help you to find profitable trading opportunities. You don’t have to become an expert in economics to gauge market performance; but you do need to know what you’re looking for and how to use the information that’s out there. 

Part of a trader’s learning curve depends on his or her ability to integrate an understanding of the big picture with the multitude of details that trading individual stocks requires. Since money is the lifeblood of the stock market, understanding how it moves and where it moves to is a major key to financial success. Not only events move the markets, but also the international flow of money as investors seek the highest possible rate of return. The thought of international money flow may be overwhelming to many of us, but it is an important part of the big picture. So put on your high waders, the water’s just fine.

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