Traditional ETFs

Traditional ETFs are available on the big market indexes, like the Standard & Poor’s 500 and the Dow Jones Industrial Average. They are also available in a variety of domestic bond indexes, international stock indexes, foreign currencies, and commodities. Because traders are often interested in a market segment that doesn’t have an index on it, some ETF companies develop their own niche indexes and issue ETFs based on them. Hence, you can find ETFs for such markets as green energy and Islamic investing. The liquidity in the securities in the underlying index may be low, though, so these funds may be more volatile in trading — and may even have arbitrage opportunities.

Traditional ETFs can be used as long-term investments, and traders can use them. The retail shares can be sold long or short, or traded on margin, so they’re a useful way to place trades on broad market trends or to take advantage of short-term technical opportunities.

Strategy ETFs

Not all ETFs trade on stock indexes. Many are what are known as strategy ETFs, funds that are based on a hedge fund–investing strategy rather than an underlying index. They can be dangerous for long-term investors who don’t know what they’re buying, but hey, this book is for traders! As with traditional ETFs, a strategy ETF can be held for the long term, or the shares can be traded long, short, or on margin.

Instead of setting up a portfolio of stocks and bonds to match an index, a strategy ETF may have a portfolio manager who chooses the investments. It may use options, futures, leverage, or short selling to generate an investment result that matches an index – or that deviates from it in more or less predictable ways. Its risk and return structure is different, and recognizing that information upfront can reduce heartache and improve profits.

Traders often find great opportunities in strategy ETFs. They give you a bigger toolbox to use to take on the markets, especially in times when the market is under stress. Just keep in mind that a strategy ETF may move in strange ways, especially if you’re looking at it for more than a few minutes of trading.

How U.S. ETFs trade

For day traders, the advantage of ETFs is that they can be bought and sold just like stocks. Customers place orders, usually in round lots, through their brokerage firms. The price quotes come in decimals and include a spread for the dealer.

The fact that ETFs trade the same way that stocks do makes them relatively easy for you to get started. You need a brokerage account with a margin agreement.

Some brokers waive commission for trades in certain ETFs, but this benefit is designed for long-term investors. Because commission is rarely waived for day traders, you’ll want to compare total costs including execution rather than simply looking at the commission rate.

Traders can use ETFs to trade on trends in a relevant sector. For example, a trader who sees that a broad market index is headed for a breakout in the next hour or so may look to make a profit on that by taking a long position in an ETF that is tied to that index. Other traders may look at the trading patterns and indicators for a particular ETF and make a trade based on the performance of the ETF rather than that of the underlying index.

Being aware of risks of ETFs

ETFs have changed the trading game over the years, and new products are being introduced all the time to expand the range of ways that investors and traders can manage their market exposure. But for all their popularity, two big risks remain:

• The first risk is tracking error, or the difference between the value of an ETF and the value of the index or strategy that it’s supposed to track. The creation units are designed to manage the tracking error; the idea is that the big trading firms that make up the authorized participants engage in arbitrage (refer to the later section, “Comprehending Arbitrage and the Law of One Price”) to force the values into alignment. Most of the time, the process works like a charm, but every now and again, ETF values get way out of whack. This usually happens when the markets are having a wild day and traders are using ETFs to make a profit the volatility.
• The second risk is choosing the wrong ETF. The increase in strategy ETFs increases this risk. A trader who isn’t paying attention may take a position in an ETF that won’t behave in a predictable way or at least not one that follows the same logic as an ordinary stock or bond. At an extreme, the annals of finance are full of sad stories of investors who took large positions in inverse ETFs after a down market year because these funds seemed to perform so well, without realizing that an inverse ETF would be down in a year that the market goes up. Ouch!

Bitcoin and blockchain

Bitcoin emerged in 2009 in an academic paper written by an author or group of authors using the name Satoshi Nakamoto. (You can find the original paper at https://bitcoin.org/bitcoin.pdf.) Nakamoto set up the idea of an electronic coin that was actually a chain of digital signatures — a blockchain. When a coin is transferred from one owner to another, a code is added to the blockchain known as a hash. The hash includes data about the previous transaction and the public key of the next owner. Someone can go through to verify these hashes to show the chain of ownership.

Bitcoin was designed specifically as a reward for solving a series of increasingly difficult equations (which requires a lot of computer power and electricity.) The total number of Bitcoin that can be found is limited. The idea is to be a new currency that operates independently of the banking system, that can’t have its supply manipulated by government planners and that carries built-in protection against fraud and theft.

Note: Blockchain isn’t the same as cryptocurrency. Blockchain itself has a lot of applications for tracking the movement of goods from one place to another, documents from reader to reader, or securities from one trader to another. It’s a great innovation, but it isn’t a tradable asset. You don’t need to use Bitcoin to use a blockchain.

In theory, Bitcoin could replace all the money in the world. In that case, each Bitcoin could be really valuable. Or, it could become completely worthless because people come to see it as a game developed by a few programmers. It’s too soon to know. If I had to take a guess, I’d say that traditional currencies mostly work quite well and aren’t going away soon — although bank accounts could well be managed by blockchain someday.

Other cryptocurrencies

As Bitcoin caught on, other cryptocurrencies were developed to capitalize on the demand or to make refinements on the concept of digital money. Some of them address the function of the blockchain, whereas others have different approaches to currency creation. And some even started out as jokes, such as the case with Dogecoin. They all have the same underlying problem as Bitcoin — they aren’t used in commerce. They all have the same potential payoff, if there is a fundamental change in the way money is created and used in the world.

Units of cryptocurrency are often referred to as coins or tokens. The following sections examine the two main ways that new cryptocurrencies are created:

Understanding how cryptocurrencies trade

The market for cryptocurrencies is wild. It’s based on supply and demand, of course, but the supply and demand is mostly driven by the interest of traders. Unlike with regular currencies, people aren’t supplying or demanding cryptocurrency to import machine parts, pay for a hotel room in another country, or buy stocks trading in emerging markets. Many people who are active in the crypto world believe that the replacement of regular money with cryptocurrency will happen sooner rather than later, so they tend to buy and hold their coins – or hodl them, a slang term based on the misspelling of hold.

Some merchants accept cryptocurrency, although most of them immediately exchange it for traditional currencies. Some folks engaging in illegal activities prefer cryptocurrency because the blockchains create anonymous receipts, which is why crypto is often used for ransom in data thefts or as a form of exchange for online drug deals. Some people experiment with cryptocurrencies in countries without a stable currency, such as Argentina or Venezuela, but they represent extremely small parts of the global economy.

In the next sections, I cover some of the unique aspects of cryptocurrencies that day traders need to consider. Crypto is almost, but not quite, like other assets that you may want to trade.

Watching out for the risks of cryptocurrencies

Day trading is risky. Right now, trading in cryptocurrencies is even riskier than day trading. Of course, that risk creates opportunities if you know what the biggest risks are ahead of time. Here are some risks:

• Cryptocurrencies may have absolutely no value whatsoever. I can’t emphasize this point enough. No one knows if cryptocurrency in general will catch on, let alone any particular coin.
• The security of the wallet is another risk. Because blockchain is anonymous, whoever “finds” a coin can keep it. There haven’t been many crypto thefts, but there have been enough that you should be pay attention to security when looking at wallets and exchanges.

A lot of people become interested in cryptocurrency because of their political leanings. They think that the government shouldn’t be in the business of issuing currency for all sorts of reasons. However, the number of people holding these political beliefs doesn’t mean that the market for cryptocurrency is going to take off anytime soon. You have to trade what you see, not what you want to see happen. A sincerely held political belief is nothing more than a wish, and the market doesn’t trade on wishes. Make political change by voting, not by trading cryptocurrency.

Getting to know types of derivatives

Day traders are likely to come across three types of derivatives: options, futures, and warrants. Options and futures trade on dedicated derivatives exchanges, whereas warrants trade on stock exchanges.

Buying and selling derivatives

Derivatives trade a little differently than other types of securities because they are based on promises. When someone buys an option on a stock, they aren’t trading the stock with someone right now; they’re buying the right to buy or sell it in the future. That means that the option buyer needs to know that the person on the other side is going to pay up. Because of that, the derivatives exchanges have systems in place to make sure that those who buy and sell the contracts will be able to perform when they have to. Requirements for trading derivatives are different than in other markets.

The different exchanges, not the companies or industries covered by the contracts, issue options and futures. You can buy and sell them through any brokerage firm that is registered with the exchanges. Most brokers handle options, but not all handle futures. (To be precise, a broker that handles futures is known as a futures commission merchant, or FCM). Your broker will require you to sign a form called an options agreement to show that you understand the risks involved in trading them.

The options and futures exchanges have an interest in getting more people to trade their products, so they offer great educational resources. The CME Institute has a lot of information that can help get you started at https://institute.cmegroup.com/.

Understanding how arbitrage and market efficiency interact

The law of one price holds as long as markets are efficient, although market efficiency is a controversial topic in finance. In academic theory, markets are perfectly efficient, and arbitrage simply isn’t possible. That makes a lot of sense if you’re testing different assumptions about how the markets would work in a perfect world. Long-term investors would say that markets are inefficient in the short run but perfectly efficient in the long run, so they believe that if they do their research now, the rest of the world will eventually come around, allowing them to make good money.

Traders are somewhere in the middle in their perspective of market efficiency. The market price and volume are pretty much all the information they have to go on. The price may be irrational, but that doesn’t matter today. The only thing a trader wants to know is whether an opportunity exists to make money given what’s going on right now.

In the academic world, market efficiency comes in three flavors, with no form allowing for arbitrage:

• Strong form: Everything, even inside information known only to company executives, is reflected in the security’s price.
• Semi-strong form: Prices include all public information, so profiting from insider trading may be possible.
• Weak-form: Prices reflect all historical information, so research that uncovers new trends may be beneficial.

Those efficient-market true believers are convinced that arbitrage is imaginary because someone would’ve noticed a price difference between markets already and immediately acted to close it off. But who are those mysterious someones? They are day traders! Even the most devout efficient-markets adherent would, if pressed, admit that day traders perform a valuable service in the name of market efficiency. The 2008 financial crisis and the 2010 flash crash thinned the ranks of the efficient-market true believers.

Those with a less rigid view of market activity admit that arbitrage opportunities exist but that they are few and far between. A trader who expects to make money from arbitrage had better pay close attention to the markets to act quickly when a moment happens.

Finally, people who don’t believe in market efficiency believe that market prices are usually out of sync with asset values. They do research in hopes of learning things that other people don’t know. This mindset favors investors more than traders because it can take time for these price discrepancies to work themselves out.

Because arbitrage requires traders to work fast, it tends to work best for traders who are willing and able to automate their trading. If you’re comfortable with programming and relying on software to do your work, arbitrage may be a great strategy for you. Remember that the big players have an advantage.

Creating synthetic securities

If you’re feeling creative, then consider creating synthetic securities when looking for arbitrage opportunities. A synthetic security is a combination of assets that have the same profit-and-loss profile as another asset or group of assets. For example, a stock is a combination of a short put option, which has value if the stock goes down in price, and a long call option, which has value if the stock goes up in price. By thinking of ways to mimic the behavior of an asset through a synthetic security, you can find more ways for an asset to be cheaper in one market than in another, leading to more potential arbitrage opportunities.

A typical arbitrage transaction involving a synthetic security, for example, involves shorting the real security and then buying a package of derivatives that match its risk and return. Many of the risk-arbitrage techniques involve the creation of synthetic securities.

One of the reasons that the different securities in this chapter were created was to help traders construct synthetic securities for both risk management and for trading opportunities. And, their very existence creates arbitrage opportunities where you may be able to profit.

Complex arbitrage trading strategies require more testing and simulation trading (refer to Chapter 13 for more information) and may possibly involve losses while you fine-tune your methods. Be sure you feel comfortable with your trading method before you commit big time and big dollars to it.

Taking advantage of price discrepancies

So how can you as a day trader take advantage of what you know about the one-price rule? Suppose that what you see in New York isn’t what you see in London, or that you notice that futures prices aren’t tracking movements in the underlying asset. How about if you see that the stock of every company except one in an industry has reacted to a news event?

Well, then, you have an opportunity to make money, but you’d better act fast because other people will also probably see the discrepancy. What you do is simple: You sell as much of the high-priced asset in the high-priced market as you can, borrowing shares if you need to, and then you immediately turn around and buy the low-priced asset in the low-priced market.

Think of the markets as a scale, and you, the arbitrageur, must bring fairness to them. When the markets are out of balance, you take from the high-priced market (the heavier side of the scale) and return it to the low-priced market (the lighter side) until both even out at a price in between.

If you start with a high price of $8 and a low price of $6 and then buy at $6 and sell at $8, your maximum profit is $2 — with no risk. Until the point where the two assets balance at $7, you can make a profit on the difference between them.

Of course, most price differences are on the order of pennies, not dollars, but if you can find enough of these little pricing errors and trade them in size, you can make good money.

Sometimes, the price differences are less than a penny, a situation the traders call subpennying. A day trader really can’t work with that amount. To see if subpennying is going on with an asset that you trade, set your price screens to display four decimal places rather than only two.

Reducing arbitrage opportunities: High-frequency trading

Most of the large brokerage firms and many large hedge funds have invested crazy amounts of time and money to develop high-frequency and algorithmic trading strategies. These strategies use computer programs that control billions of dollars and make extremely short-term trades — sometimes holding only for seconds — whenever the programs spot short-term discrepancies in the market. In some ways, this practice has made the market more efficient, because these program traders fix prices that are out of whack in no time. But they have also added to volatility, sometimes due to program glitches and sometimes because the trades go on even when they shouldn’t, because no human is there to stop them.

In fact, many observers of the market microstructure, which is the underlying trading environment, think that the amount of high-frequency and algorithmic trading has reduced efficiency. They see evidence that the larger number of market participants have led to knee-jerk reactions when different programs malfunction or entire systems fail. The downside for the day trader is that these programs have eliminated many arbitrage opportunities that once made up the bread and butter of many a trader’s earnings.