In This Chapter

Position trading and trend trading are extensions of the active trading philosophy of grabbing profits, then exiting the trade. The only difference is the time period. Some call position and trend trading short-term investing. True investors will generally stick with a good company as long as nothing has fundamentally changed, even if the stock price has dropped due to market conditions. Position traders won’t wait for companies to have a better price in the market. They are focused on stock price alone. Price trends that may annoy buy-and-hold investors can be profit machines for position and trend traders.

Another form of active trading that is less well known outside the industry is arbitrage trading. Arbitrage trading can be relatively risk-free or quite edgy, depending on which form you try. The varieties of arbitrage trading allow for holding strategies that range from a very short duration to much longer.

Position trading is the most laid-back form of active trading. If you think of day trading as a frantic grab for profits during the market day, position trading is capturing a stock at the beginning of an upward (or downward) price trend and riding it up as far as it will go. As long as the stock’s price continues to rise and shows no signs of halting, position traders sit tight. When traders see signs of weakening momentum, they take steps to protect existing profits and prepare to exit.

Obviously, the longer the price trend continues, the more profit position traders make. Position traders have no predetermined hold period. The price of the security controls the hold. If traders are clever, they will take their profits just before the trend collapses or runs out of momentum. It is difficult to know exactly when this will happen, so position traders watch weekly technical analysis charts for specific events that suggest it is time to throw in the towel.

The trend may last a week, a month, or many months. Technical indicators play a big role in keeping the trader informed about pending trouble or price changes. Moving averages (see Chapter 4) play an important role in position trading as reference points. Major securities’ indexes also are used to spot changes in price trends.

Like swing traders, position traders expose themselves to the risk of time. The longer you hold a security, the greater risk there is that a company or an economic event will overtake the stock and destroy your trading strategy. That is why position traders need to keep current on events that may have an impact on their positions.

The point of active trading is to take profits and exit trades before price changes take profits back from you. Position trading is no different from other forms of active trading in its goal. It simply is another tool that allows active traders to “let profits run” when a security is on a price-changing trend. While many people think only in terms of buying low and selling high, traders always consider the other side of trading, which is selling high and buying low. Short selling is an effective tool for the position trader since downward price trends are as profitable as upward price trends.

Position traders look for securities that can move over longer periods. Stocks are good candidates, although other securities also work. Stocks are preferred by many active traders for all the same reasons other traders prefer them: liquidity, ready markets, abundance of information, and so on. Stocks can also be linked or paired with major indexes in charting programs, which is an important strategy in identifying candidates for position trading. More about this later.

Because there is no product life to stocks—as there is on many derivatives, such as options and futures—position traders could keep a trade open as long as they wanted. To be faithful to the position-trading strategy, you would close out your trade as soon as the profits show signs of evaporating, but that could be days, weeks, or months.

Position trading opens you to the risks of time. While short-term trading has its own set of risks, it avoids the risk of time by closing out all trades at the end of each day. This prevents any bad company or economic news from hurting the traders after the market closes. Swing traders have some exposure to the risks of time, but it is usually limited to a few days at most. The longer traders hold a trade open, the greater the risk that something will happen to destroy their strategies.

Position traders typically monitor daily and weekly charts to watch for potential price trend reversals. When the technical analysis signals a possible reversal, clever position traders take their profits and move on to the next trade. However, technical analysis charts won’t predict all the bad things that can happen to a company. A major product recall, unfavorable court rulings, allegations of fraud, poor earnings, and so on can wreak havoc on a company’s finances and stock.

When stock prices change on bad news, they can change dramatically and move suddenly. Even with standing stock orders, you may find yourself selling in a market that can’t fill your order at the price you want, so you sell for much less than you hoped to get.

Short selling is one way position traders make money in a bearish market or by playing a bearish stock sector. Traders are counting on the downward price trend continuing to make profits. Position traders will sell stocks they have borrowed from their brokers that appear to be heading downhill. As long as the stock continues to go down, position traders are in a good spot to make money. When it looks like the stock is about to bottom out, traders buy the stock at the reduced price and replace the shares they borrowed from their brokers.

While it sounds like an easy way to make money (in a bearish market, there are many opportunities), short selling as a position trader has its risks. Like all short sellers, position traders must be aware of the risks should the stock reverse direction and begin to rise in price. You suddenly might have to buy the stock at a much higher price than you sold it. To replace the stock that you borrowed from your broker and then sold short, you must buy shares on the open market. If the stock is rising rapidly in price, you might find it difficult to buy replacement shares at a good price.

Position traders must be careful about the stocks they pick for shorting. In most cases, you are better off shorting a large-cap, widely traded stock. The reason is that if the price reverses and begins to rise, you’ll want the stock to be widely traded so you won’t have trouble buying replacement shares. When stock prices begin to rise and short sellers can’t find enough replacement shares—as would be the case with small-cap stocks (stocks of small companies)—they bid the price even higher. This is known as a short squeeze, and it can result in a disaster for the short position trader.

The distinction between position trading and investing may seem tenuous at best. Many would say that any holding beyond a year is investing and it is possible for position traders to hold a trade that long. However, beyond the holding period, there is a difference between position trading and investing.

Investors are not concerned with daily or weekly price changes. They look for companies that are building future value through their business model. Investors believe that a company’s stock price is a reflection of its ability to generate earnings and dividends for shareholders. As the company gains market share and grows new product lines, the revenue will rise and earnings will increase. This will ultimately lead to a higher stock price, if not now, then at some point in the future.

Traders don’t care about earnings or dividends except as they might affect immediate stock prices. Poor earnings can mean a lower stock price, so position traders keep an eye on fundamental news. However, traders have no interest in a future payoff. Current profit is the goal, and only those actions that affect today’s stock prices are of concern. Position traders want to see the stock continue to rise, but aren’t willing to sit through a slump in price, while investors will if they still believe in the company. As soon as traders receive any indication that the stock’s price is about to reverse direction (from technical analysis or fundamental news), they will exit the trade.

Position trading is often called trend trading. The idea behind trend trading is that once prices establish a movement in one direction they tend to continue in that direction until they meet resistance or a fundamental factor changes. This acknowledges the psychology of market prices and proves correct more often than not. Traders say the trend is your friend because you want to go with the movement of prices, not work against it.

Trends can be short, medium, or long in duration. Position trading falls in the medium and long range. It doesn’t matter which direction prices are going; the important work of the trader is to identify the trend and jump on as soon as the trend is confirmed. When the trend begins to falter, traders should exit with their profits.

The trend is your friend until the end, when you want to abandon it quickly to prevent prices from reversing course and eroding your profits.

Unlike short-term traders who have a profit target, position or trend traders are willing to let their profits run. However, they protect their profits with automatic sell orders that follow the price of the stock as it rises. (More about these protective orders in Chapter 13.) Because a stock may reverse its price run for a variety of reasons that can’t be seen, it is wise to stay tuned in to technical and fundamental indicators that may signal a reversal.

If there were a way you could make profits without risk, you would probably want to know about it, wouldn’t you? That sounds like a pitch from a late-night infomercial. However, it describes an actual form of trading known as pure or true arbitrage. Arbitrage trading is a form of trend or swing trading that is distinctive in its strategy.

True arbitrage involves trading assets that concurrently trade at different prices on different markets. You buy the asset on the market where it is at the lower price and sell it on the market where it is selling at the higher price. Assuming the spread between the two prices is sufficient to cover your trading costs, you have a profit with no risk.

Do such trades exist in the real world? Yes, they do. However (you knew there would be a catch, didn’t you?), the reality is that most active traders have little chance of capturing pure arbitrage trades. The reason is when these inequities pop up in the market, they last a very short time. Major institution investors and market makers with sophisticated software are usually the first to spot them. Many employ specialized software that trolls the markets looking for arbitrage opportunities. Programmed trading executes orders without human intervention when the trade meets certain qualifications.

The differences in prices are often very small, so huge orders using a large amount of leverage are employed to turn the opportunity into a money maker. Most active traders lack the technical and financial resources to compete in pure arbitrage trading situations. That doesn’t mean there aren’t other arbitrage opportunities for them to explore.

Since pure arbitrage opportunities are rare for active traders, they must look to other types of trades. The most common type of arbitrage employed by active traders is generally called risk arbitrage. Risk arbitrage takes several forms, but it always involves trading securities with a price inequality. The difference is the securities are not the same as they are in pure arbitrage. You still buy one and sell the other—the key is understanding the relationship between the two securities and how the price inequity works.

Trading two securities that are similar or related in some way is not the same as trading the same security at two different prices. That’s, in part, where the risk comes into the trade. The securities are related but not the same and will react in ways that may not be expected. However, if you understand the dynamic of the relationship—more about that next—you can profitably engage in risk arbitrage.

Another significant difference between pure and risk arbitrage is that while pure arbitrage usually settles out quickly, risk arbitrage can take days or weeks to balance the price of the two securities. Because the securities are different, the market dynamics to bring them into balance may not be as strong. This is not extra time to study the trade, but time for the trade to mature. In many risk arbitrage trades, you will still need to act with some speed to get in before prices of the securities narrow the gap.

This is the most common form of arbitrage and one that active traders can cash in on if they are looking for the opportunities and are willing to move quickly. Typically, a company will announce that it plans to buy another for a price that is some premium over where the stock is currently trading. Two things happen: the acquiring company’s stock often drops because of the risk the deal won’t go through, and the acquired company’s stock will rise, but not all the way to the offered level. Investors will hold back because of the risk that the deal won’t happen.

The active trader will immediately short the acquiring company and buy the acquired company. If things happen as they should, the acquiring company’s stock will drop and the trader can profit from shorting it. In addition, the acquired company’s stock will rise when investors realize the deal will go through and the trader profits there, too.

Options on stocks form the basis for dozens of strategies for active traders interested in arbitrage trading. Here you are trading a derivative and a stock in tandem to accomplish your goal. Stock options, for example, are tied to the underlying securities. As the price of the stock moves, so should the option. When there is a discrepancy, active traders can step in and profit.

If the stock is trading on the market lower than its options seem to indicate (meaning the options market believes a higher price is warranted), the active trader can buy shares of the stock and execute an options strategy that effectively sells the shares at the higher price. (The options market is beyond the scope of this book. You should have an understanding of it before attempting this type of trade.)

Pairs trading is a type of arbitrage that exploits the relationship between two securities that tend to move together most of the time. Active traders are looking for securities that are highly correlated—that is, they move in tandem to the same influences most of the time. A common example is Ford and General Motors. However, you can also use market indexes, options, futures, and other securities. What is important is the relationship. The opportunity for profit comes in when these highly correlated securities diverge in price.

When that happens, the active trader can short the security that is overpriced and buy the security that is underpriced relative to the pair’s historical relationship. The active trader is counting on a correction that will bring the two securities back into track with one another. This will mean the overpriced security will fall in price and the trader will profit on the short trade. It will also mean the underpriced security will rise in price and the trader can sell for a profit. The risk is that the two will either not converge or converge at a new level that makes the trades unprofitable.

Market indexes such as the S&P 500, the Dow, the Nasdaq Composite, and many others are also the basis for popular trading vehicles (see Chapter 6). All of the major and some of the minor indexes are covered by mutual funds and exchange-traded funds. In addition, you can buy options and futures contracts based on the indexes. With each index represented by multiple securities there is plenty of opportunity for arbitrage players to find pricing inequities. These differences may not always be large enough to make a profit, but this is fertile ground for arbitrage traders.

Traders with a keen understanding of derivatives (options and futures) and their pricing relationship with the underlying asset can create an artificial arbitrage opportunity. By utilizing the product characteristics of options and futures, traders can construct arbitrage (buying at one price and selling at another) when the pricing relationship with the underlying asset is not as it should be.

Up until recently, such trades were only available to hedge fund managers, institutional investors, and other traders with deep pockets and access to the information and technology to make them happen. The Internet has opened the door for many active investors to execute complicated trades based on the same information previously available only to a certain class of investors and traders.

Live price information and sophisticated trading models combined with high-powered personal computers have made this sophisticated form of trading possible. Traders with extensive knowledge of derivatives can put that knowledge to use constructing buy and sell models that effectively give them a low-risk arbitrage trade.

That level of trading is beyond the scope of an introductory book to active trading. However, if you are interested in a career as an active trader you should know that you are not limited to simple transactions that make up the bulk of the examples in this book.

Arbitrage trading is a form of active trading that experienced traders should investigate. You can make a good living without it, but arbitrage is another tool for making money as an active trader and one you should consider if you plan to make a career of trading. However, it is not the place to start your active trading career. Arbitrage trading is for more advanced traders who have some experience in the markets and are comfortable with complex securities and complicated trades.

The Least You Need to Know