Chapter 16
Regulation Right Now
IN THIS CHAPTER
Identifying the regulators
Considering basic brokerage requirements
Avoiding insider trading tips
Protecting the markets in crisis situations
Following procedure when you take on partners
The financial markets are wild and woolly playgrounds for capitalism at its best. Every moment of the trading day, the actions of buyers and sellers determine 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 well most of the time 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.
As a day trader, you may not be managing money for other investors, and you may not answer to an employer, but that doesn’t mean you don’t have rules to follow. Day traders have to comply with applicable securities laws and exchange regulations, some of which specifically address those who make lots of short-term trades. Likewise, brokers and advisors who deal with day traders have regulations that they need to follow. Understanding all these different rules and regulations can help you make better decisions about whom to deal with. In this chapter, you find out who does the regulating, what they look at, and how they affect you.
Looking Back on the Road to Regulations
With the advent of the telegraph, traders were able to receive daily price quotes. Many cities had bucket shops, storefront businesses where traders bet on changes in stock and commodity prices. These traders weren’t buying the security itself, even for a few minutes; instead they were 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 began trading off the ticker tape, which was a printout of price changes sent by telegraph, or wire. In most cases, traders made these transactions 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 got wires installed in their own offices, but the costs were prohibitive for most individual investors. In any event, traders still had to place their orders through a broker. Because they didn’t have direct access to the market, they couldn’t 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 (SEC) ruled that this practice amounted to price fixing. After this ruling, brokers could 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 SEC called for several changes designed to 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 1,000 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.
SOES coincided with the rise of the commercial Internet, making the late 1990s a golden era for day traders, at least in the popular imagination. More and more discount brokerage firms offered Internet trading while Internet stocks became wildly popular. No one needed SOES to make profits when Pets.com and Webvan were going up in price day after day, at least for a while. (Remember that? No? Well, it was fun while it lasted.)
Then market for tech stocks cratered in 2000, in part because so many of the companies cratered, too. For much of the next decade, the markets were mostly quiet while new products were introduced that appealed to day traders, including exchange-traded funds and miniature commodities contracts (both of which are discussed in Chapter 3).
And then things got crazy. In 2008, brokerage firms failed, and the financial markets came darn near close to collapse. All that volatility was a lot of fun for those traders who could handle it. The brokerage firms developed larger and more sophisticated trading programs that seemed to work well until a single large order on the afternoon of May 6, 2010, caused everything to go haywire. That so-called “flash crash” exposed the risks created by high-frequency trading programs; at first, no one wanted to blame technology and instead tried to place the blame on traders whose fingers were too big to punch the numbers on their order-entry machines.
The financial system received generous government bailouts in the fall of 2008 in the hopes of staving off another depression. The exchanges and the federal government created new regulations in the major institutions, although little has changed for day traders, even a decade later.
So what are the regulations that affect day traders? Well, keep reading!
Reviewing the Regulators
In the United States, financial markets receive general regulatory oversight from two government bodies: the 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. In the currency market, by contrast, the only issuers are governments, and there are a lot fewer of them than there are public companies. When one of these companies turns out to have 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 have changed 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)
The SEC (www.sec.gov) 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
In addition to its standard regulations, which brokerage firms know by heart, the SEC occasionally passes temporary regulations in times of market stress that may affect day traders. For example, during the 2008 financial crisis, the SEC placed restrictions on short selling the stock of different financial companies.
The Financial Industry Regulatory Authority (FINRA)
FINRA (www.finra.org) was formed in 2007 by the merger of the New York Stock Exchange’s regulatory department and the National Association of Securities Dealers. It represents and regulates all stock and bond brokerage firms and their employees. More than 3,712 firms are members, with 629,112 employees registered to sell securities. FINRA 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 number of firms keeps decreasing as the industry consolidates, but the number of industry workers has been more or less constant.
FINRA also requires brokers to know who their customers are and whether an investment strategy is suitable for them, the so-called know your customer rule. I discuss suitability later in this chapter, but for now, know that that’s a FINRA function.
A good first stop for a day trader is FINRA’s BrokerCheck service, which you can find at www.finra.org/Investors/ToolsCalculators/BrokerCheck. BrokerCheck allows you to look up brokerage firms and individual brokers to see whether they’re in good standing. If any complaints have been filed, you can see what they are and decide for yourself how you feel about them. This great information can help you head off problems with sales people or brokerage firms early on. BrokerCheck has helped me a time or two when I’ve been looking into potential business partners.
FINRA’s predecessor, the National Association of Securities Dealers, 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 don’t trade on an organized exchange like the NYSE). 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 FINRA.
The exchanges
Although the NYSE and Nasdaq got out of the brokerage oversight business when they formed FINRA, they are both involved in regulation. In particular, these and the smaller exchanges work to ensure that companies with securities traded on the exchange meet the criteria set for their listings. These criteria include timely financial reporting with the SEC and minimum numbers of shares that are actually traded. (Chapter 3 has a description of the different exchanges and their listing requirements.)
The exchanges also monitor how securities are traded in order to look for patterns that may point to market manipulation or insider trading. Each exchange works with the brokerage firms that are allowed to trade on its exchange to make sure that the brokers know who their customers are and that the brokers have systems in place to make certain that their customers play by the rules.
The Federal Reserve System
The Federal Reserve System, known as the Fed to friend and foe alike, is the central bank of the United States, and one of its roles is to ensure the integrity of the country’s financial system. Although most Federal Reserve regulation is aimed at commercial banks, the Fed gets involved in securities markets in times of crisis to ensure that the markets continue to function. In the 2008 financial crisis, this involvement included arranging the mergers of failing brokerage firms as well as buying troubled assets from different banks, brokerage firms, and insurance companies.
The Securities Investor Protection Corporation
The Securities Investor Protection Corporation (SIPC) was founded in 1970 to protect brokerage accounts from losses in the event of the firm’s bankruptcy. If your firm goes under (and several have over the years, including some that were once household names), you’ll be able to get your cash and securities back.
The SIPC doesn’t insure against fraud, however. If you’re dealing with a firm or a salesperson who rips you off, you have to get redress through the courts and the SEC. You want to find a brokerage firm that is an SIPC member, but your due diligence can’t stop there. For example, you should check your broker through FINRA’s BrokerCheck, discussed in the earlier section “The Financial Industry Regulatory Authority (FINRA).”
Likewise, almost all disputes that clients have with brokerage firms go to arbitration, not the courts, and many people believe that the arbitration process is biased in favor of the brokers. You have recourse, but you may not have as much as you would like.
Treasury bond market regulation
Treasury bonds are a slightly different animal than corporate bonds. The U.S. government issues them, so the Treasury Department’s Bureau of the Public Debt (www.treasurydirect.gov) handles regulation, with the SEC providing additional oversight. The firms that trade Treasury bonds are FINRA members, so those rules apply, too.
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 these traders 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 are familiar.
Commodity Futures Trading Commission (CFTC)
The CFTC (www.cftc.gov) 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)
The NFA (www.nfa.futures.org) regulates 3,666 firms with 49,416 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’re 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 any complaints have been filed, you can see how the problem was resolved. (Consider BASIC the futures equivalent of the legendary permanent record that your elementary school teachers said would follow you for the rest of your life.)
The SEC and the National Association of Securities Dealers regulate trading in options on stocks, but the Commodity Futures Trading Commission and the National Futures Association regulate trading on options on futures. As the lines between derivative products get blurrier, you may find a lot of overlap between these different organizations, and many experts in the industry predict that the SEC and CFTC will merge at some point. Because researching firms and people through several self-regulatory organizations is possible, 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
Unlike the stock exchanges, the derivatives exchanges haven’t merged their regulatory functions. Thus the Chicago Board Options Exchange (CBOE), the CME Group, IntercontinentalExchange, 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. (Chapters 3 and 4 describe the different exchanges and what they do.)
To look for patterns that may point to market manipulation or insider trading, the exchanges also monitor how derivatives are traded. Each works with the futures commission merchants that are allowed to trade on its exchange to ensure that the FCMs know who their customers are and have systems in place to make sure these customers trade well, if not profitably.
On occasion, the exchanges cooperate with regulators of stock and bond markets, especially if the suspicion of fraud or market manipulation exists. After all, insider trading in options is just as illegal as insider trading in stocks!
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 a simple exchange of bucks to loonies. Unfortunately, this situation has allowed some firms to misrepresent forex trading to day traders as regulated when it is not, which has allowed some day traders to get badly burned. Forewarned is forearmed, as the cliché goes.
Cryptocurrency, by the way, has even less oversight, other than for criminal theft or fraud — if the perpetrators can be identified.
Some online forex brokers are located outside of the United States, so they are allowed to offer customers more leverage. Increasing leverage can increase return, but it also adds risk. And some jurisdictions have better protections for investors than others. Check to see where a firm is based and what laws apply so that you’re protected.
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 day traders prefer to pick up exposure to currency using options and futures, to bet on where exchange rates may 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’re always 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. Therefore the Federal Reserve Banks and the U.S. Treasury Department pay attention to forex markets, looking for evidence of manipulation and money laundering (discussed later in the chapter). This oversight 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 you from the outlandish claims made by crooked forex trading firms, but it does ensure that your contracts are fulfilled.
Working with Brokers’ Rules
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 to do even more.
Gauging suitability
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’re trying to do, you may have to submit financial statements, sign a stack of disclosures, and verify that you have received different guides to trading.
Your financial situation is 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 risks that they shouldn’t be taking. That’s why the brokerage firm wants to know who you are and what money you’re using for your trading. 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 you lose it, you can’t say you didn’t know about the risks involved.
Making sure the money is legit
Money laundering is the process of creating a provenance for 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, either. 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; he can’t 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 looks for a way to make it appear that the money is legitimate. All sorts of ways to launder money exist, 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, which is why legitimate brokerage firms opening day-trade accounts pay 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 Enforcement 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 information when you open a brokerage account:
- Your name
- Your date of birth
- Your street address
- Your place of business
- Your Social Security number or Taxpayer Identification Number
- Your driver’s license and passport
- Copies of your financial statements
Following 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, discussed in great detail in Chapter 5). 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.
FINRA has a long list of rules that its member firms have to meet to stay in business. Rule 4210 deals specifically with day traders. This rule 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, although they give some flexibility on maintenance margin.
FINRA 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 FINRA Rule 4210 matters: If you are a pattern day trader, you can have a margin of 25 percent in your account, which means you can borrow 75 percent of the cost of the securities that you’re trading. Most customers are only allowed to borrow 50 percent. The reason for the higher amount? Pattern day traders almost always close out their positions overnight, so the firm has less risk of having the loan outstanding. However, you have to have a margin account if you are a pattern day trader. That is, 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 4210, you have to have at least $25,000 in your brokerage account at the start of the trading day. If you have losses that take your account below that, you have to come up with more money before your broker allows you to continue day trading. 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.
Don’t bother trying to plead your case, because the broker has to comply with the law. Firms pay a price if they let customers slide. In 2010, FINRA fined brokerage firm Scottrade $200,000 for allowing customers who met the definition of pattern day traders to trade without maintaining $25,000 in their accounts. The firm sent customers warnings but allowed them to trade in violation of the rule — a decision that wasn’t cool with the regulators.
The rules set by FINRA 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.
Reporting taxes
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, after the end of the year, the brokerage firm sends you form 1099B listing how much money you made in your account, breaking it out between income and capital gains on stocks, bonds, options, and futures. You use that to ensure that the taxman gets his cut. Tax issues are covered in Chapter 17, but for now, just keep in mind that your federal, state, and local taxing authorities are paying attention to how well your trading does.
Watching Out for Insider Trading
The regulations about suitability and money laundering are very clear. 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.
But another set of rules also keeps markets functioning — namely, that no one has an unfair information advantage. If you knew ahead of time 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. In doing so, however, you’d have an unfair advantage. If everyone believed that such unfair advantages were common, then they would be unwilling to participate in the capital markets, and that would harm the economy.
Insider trading is not well defined. Insider information includes any nonpublic information that a reasonable person would consider when deciding whether to buy or sell a security, 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, who buy and sell so quickly, can be susceptible to hot tips. They may be participating in message boards, private social media groups, or chat services where hot rumors can get the blood flowing on a dull day. 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 — and you act on this information in your trades or share it with someone who then acts on it, you may be looking at stiff penalties. Civil penalties are usually three times your profits, but the government may 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 the past several days to see whether any unusual activities occurred in relevant securities and derivatives. Then they start tracing that activity back to the traders involved through the brokerage firms to see whether the activity was coincidence or part of a pattern.
By the way, most tips turn out to be groundless, or at least not as interesting to the market as it seems like they will be. Real insider information is hard to get, but starting a rumor is easy-peasy.
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.
Preparing for Rule Changes in Crisis Conditions
Many regulators sit on the sidelines, watching the markets with little interaction until a big crisis hits. When that happens, they rush in to calm the markets, often by setting up new and temporary rules until everyone is calm and normal market activities can resume.
Three main types of rules apply only in a crisis. They’re circuit breakers, short-selling restrictions, and broken trades.
Circuit breakers are temporary halts on trading that apply when the market has excessive volatility, at least in the eye of the NYSE. (Traders love volatility, but the NYSE isn’t so keen.) Here’s how circuit breakers work:
- If the S&P 500 Index falls by 7 percent (a Level 1 decline) or 13 percent (a Level 2 decline) between 9:30 a.m. and 3:25 p.m. New York time, trading stops for 15 minutes.
- If the S&P 500 Index falls by 20 percent at any time in the trading day, the trading is halted for the rest of the day.
- A Level 1 or Level 2 decline can only happen once per day. When the market re-opens after a Level 1 decline, the market won’t halt again unless a Level 2 decline takes place. If a Level 2 decline takes place, the market won’t halt again unless a Level 3 decline takes place.
The other exchanges don’t have to follow the NYSE rules, but they often do. In addition, the NYSE has the right to halt trading in any one security if it falls by more than 10 percent in a five-minute period.
Short selling restrictions can be put into place if the regulatory authorities believe that action in one industry is dragging down the entire market. In the fall of 2008, short selling was temporarily banned on financial services stocks.
Finally, if the market really goes haywire, the exchanges have the right to break trades, cancelling the buy and sell orders that looked too good to be true. When the Flash Crash of 2010 hit, many traders were thrilled to find that they could buy shares in illustrious and profitable corporations for a fraction of their usual share price. They weren’t so thrilled when the exchanges cancelled those trades.
The SEC allows stock exchanges to break trades whenever prices in the system are “clearly erroneous,” especially if a computer malfunction is involved. Some traders allege that trades are broken even if the prices are not clearly erroneous, denying them a sure-thing profit. The guidelines allow exchanges to consider breaking a trade whenever prices vary by 10 percent for stocks priced under $25, 5 percent for stocks priced between $25 and $50, and 3 percent of stocks priced over $50. Also, the review process should begin within 30 minutes of the trade.
If you see a fabulous bargain, go ahead and make the trade, but know that it may be cancelled if that great price was due to an error.
Taking on Partners
After your day trading proves to be wildly successful, you may want to take on partners to give you more trading capital and a slightly more regular income from the management fees. You can take on partners, but it’s a lot of work, and once again, you must follow certain rules and procedures.
If you’re trading options and futures and are operating a commodity pool or working as a commodity trading advisor, you need to register with the National Futures Association. If you’re trading stocks and bonds, you have to register with the SEC unless you meet the exemption tests that let you operate as a hedge fund instead.
Registration isn’t a do-it-yourself project. For that matter, neither is ensuring that you are exempt from registration even though you have partners. An error or omission may have tremendous repercussions down the line, including fines or jail time. If you want to take on partners for your trading business, spend the money for qualified legal advice. Doing so protects you and shows prospective customers that you’re 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 understand the risks they’re taking and have enough money to lose. Hedge funds do not have to register with the SEC, but they may have to register with the NFA.
Whether or not you need to register, prospective investors will want to see proof that you know what you’re 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.