In This Chapter

The outsider perception of active traders, particularly those labeled day traders, is that they play the stock market. That is partly true—stocks are the security of choice for many active traders. However, depending on the traders’ expertise, experience, and interests, they may specialize in trading many different types of securities to fit market conditions and opportunities. The different types of securities have unique characteristics that create opportunities and impose limits on the active trader.

Active traders also trade derivatives, such as options and futures. Derivatives are so named because they derive their value from the underlying security.

You’ll need a thorough knowledge of how a security or a derivative relates to market influences before including it in your tool kit.

A security is another word for any financial instrument that conveys ownership of an asset. For example, a share of common stock gives the holder partial ownership in a corporation. However, securities can also control all or parts of other assets. A bond, an option, and a futures contract are all securities.

The other characteristic of securities is that they can be bought and sold. This is an important point because it is what makes the security a product that can produce a profit for the active trader if used correctly.

Liquidity is the ability to convert an asset into cash or, in the case of the active trader, the ability to quickly buy or sell a security. One of the reasons active traders prefer stocks is their liquidity. If traders stick with mid- and large-cap stocks, there will almost always be a ready market to buy or sell shares. This assurance makes trading stocks safer in some ways than other securities that may not have the same level of liquidity.

Swing and position traders may be fine with this definition of liquidity for the stocks they trade. In most cases, they only need the ability to get to a position when they want and to exit at the appropriate time. That degree of liquidity is not enough for short-term and momentum traders. Short-term and momentum traders need an extra measure of liquidity that allows them to move into and out of a stock without affecting the price. If a stock is not widely traded (illiquid), short-term traders may change the price with their trades. Short-term traders will make more money if they can get in and out of a stock without affecting the price.

Traders working Microsoft, for example, will probably not affect the price because the stock is widely held and actively traded. One trader’s order isn’t going to change the price by itself. However, if you trade lesser-known or not as widely held stocks, your trade may change the price, which could reduce your profit potential. Short-term traders may trade the same stock many times during the day if it presents opportunities, taking small profits each time. This won’t work if every trade you enter changes the price, up or down. It will alert other traders of your activity and they will counter with trades of their own. It is often easier to make multiple trades if you can do so without attracting attention to yourself and your trades.

Traders who use other types of securities must be aware of any special rules regarding buying and selling that may be of concern. For example, options’ contracts have an expiration date. As that date approaches, the volume of trades in the option may rise or fall depending on whether the option is profitable or not. If you want to trade futures contracts, there are certain rules regarding how much the contract can change in value in one trading day. When the futures’ contract moves the maximum amount, trading in that security is halted for the day. This can be a problem for traders caught in a position that requires them to exit. Some futures products avoid this rule, which we’ll discuss in more detail in Chapter 9.

Margin lets active traders multiply their investment capital with funds borrowed from their brokers. By increasing the amount invested, active traders multiply their profit potential—and their potential loss. The use of margin is not required, but it is a powerful tool that can extend your investment capital and add to your profits. However, it is borrowing and, like any debt, you must use it wisely. Because of the implications of irresponsible margin use, the Federal Reserve Board sets the maximum amount you can borrow.

Irresponsible borrowing in the stock market and an economic downturn combined to help bring on the stock market crash in 1929. By the time the market hit bottom in 1932, it had lost 89 percent of its value from its 1929 peak. It would not regain that lost ground until 1954.

Many of the investors during the pre-1929 market frenzy were buying with borrowed money. As prices fell, brokers called those loans. When investors couldn’t come up with cash, shares were sold at rapidly declining prices, which only fueled the collapse. To prevent that type of financial panic, Regulation T sets limits on how much a trader can initially borrow and how much must be maintained in the account.

Initially, traders can borrow up to 50 percent of the purchase price—that’s called initial margin. For example, if you want to buy $10,000 worth of stock, you could borrow $5,000 from your broker and add $5,000 from your account. This assumes you are not a pattern day trader like we discussed in Chapter 3. Those traders can borrow up to 75 percent of the purchase price because they close their trades out at the end of each day. For swing and position traders, you will only get to borrow 50 percent by law. The rule doesn’t stop there, however. Your account must maintain at least 25 percent equity or you will be required to bring it up to that level. That’s called maintenance margin.

Here’s how it works for active traders who hold a position overnight. Continuing our preceeding example, you want to buy $10,000 worth of stock. You borrow $5,000 from your broker and put in your initial margin of $5,000 from your account. (Most brokers require at least $2,000 equity in your account to open a margin account.) The most you can borrow is 50 percent, but you don’t have to borrow that much. You now have extended your buying power from $5,000 to $10,000 if you so choose.

Of course, like all borrowed money you must pay interest on your margin loan, although the rate is usually not onerous. It will add up over time, so margin works best for trades that are going to be completed in a short period. The longer you hold a margin trade open, the more interest charges build up and the harder it will be to make a profit on the trade. When you close your trade, the broker will take the proceeds and pay off the margin loan and any interest due first. What remains, after commissions, of course, is your profit or loss. You’ll face the tax consequences later. We’ll look at more tax implications in Chapter 21.

When things go well, margin can increase the return on your investment. We’ll see what happens when trades go bad after this example. You borrow $5,000 to buy $10,000 worth of stock. It rises 15 percent and you sell. What is your return on this trade?

Your return is 30 percent or twice what the stock rose because you borrowed money to make the purchase. Of course, it’s not quite this rosy, as I’ve ignored interest, taxes, and commissions. However, you still come out way ahead with the margin loan.

What happens if you did not choose wisely and the trade is a bust? Let’s look at the same setup and see what happens when you have used margin on a losing trade.

If you guessed the mirror image of the profitable trade, you were correct. Not only will margin trading magnify profits, it will also magnify losses. A 30 percent loss is bad, but it can get much worse. Margin can result in losing more money than you have invested, which is impossible in straight cash investment. Here’s every trader’s worst nightmare. The stock not only drops, it plunges on some horrible, unexpected news.

The $4,500 goes to the broker and you will have to come up with another $500 to cover the full $5,000 loan. Your $5,000 equity is gone. If you didn’t close out the account immediately, your broker would because you have fallen below the margin maintenance level required by law and the broker. Your equity (the initial $5,000) is gone and by law, it cannot drop below 25 percent of the initial margin deposit.

In this example, your account equity (assuming it was $5,000 to start) dropped to negative before you closed the account. By law, as long as you have a margin loan outstanding, it cannot drop below 25 percent of the $5,000 (initial margin) or $1,250. This number would include cash and the value of securities held in your account. If your account drops below this amount, you will get a margin call, which is a communication from your broker telling you to increase the equity in your account to the minimum. If you can’t or fail to do so within the time they give you, your broker can sell the securities in your account to pay off your loan. Some brokers don’t bother with a call, they will simply sell your securities when the equity hits their minimum mark.

Your initial margin is the basis for the percentage of margin maintenance that is required. The law requires at least 25 percent, but some brokers set the limit higher. Be sure to check this limit with brokers so that you understand their requirements.

Stocks and bonds are generally eligible for margin trading, but not all stocks. Stocks of companies that have just gone public, so-called penny stocks, and other over-the-counter stocks are not eligible. Individual brokers may have their own restrictions on certain types of stocks. The type of stocks that active traders favor generally fall into the acceptable group that most brokers will allow for margin trades.

Brokers will have a list of marginable securities and their initial margin requirements. Bonds, both U.S. and corporate, can be margined, but may have different requirements. Options and short selling margin requirements differ among brokers. Certain option trades may have their own set of margin requirements. If you are interested in trading derivatives or plan on selling short frequently, you should discover what a broker’s policy is regarding these types of trades before signing on.

Volatility refers to the range of price changes for a security over a short period. Two securities can have an average price of $10 per share. One security can fluctuate between $6 and $14 per share in price, while the other security trades between $9 and $11 per share. The first security is said to be highly volatile because the price swing is extreme. The second security is not volatile because it trades in a tight range. Short-term traders have a better chance at making a profit on the volatile stock, although the risk is greater.

One way traders talk about a security’s volatility is to measure its standard deviation. Calculating the standard deviation is a statistical measure of how much the security price will vary from its average price. The math for calculating standard deviations is complicated, but your direct access provider or broker probably provides it through research software.

The higher the number, the higher the security’s volatility. This means the price will change in a given range. This creates opportunities for traders to capitalize on those price movements. This benefits short-term traders the most since they seek to capture small profits in quick trades. A higher standard deviation and higher volatility increases the risk also. It means prices are less predictable and can be harder for swing traders to work with over multiple trading days. However, it also means the potential is there for very profitable trades. As with all trades, the more risk, the higher the potential return should be.

Stocks, in particular, and bonds are the most common securities traded by active traders, but they are not the only tools you can use to make a living as an active trader. The financial markets are extremely innovative at producing new securities that open opportunities for active traders. We have also noted that clever traders can use combinations of securities and derivatives to create unique arbitrage trading opportunities—in effect, creating new securities for trading purposes.

There are very sophisticated ways to trade securities, especially derivatives that are beyond the scope of this book. However, even using the basic features of exchange-traded funds, options, and futures will allow active traders to put together attractive opportunities in the right market conditions. That is a key factor for active traders—the ability to match tools (securities) to market conditions for the best chance at profits.

One of the newest securities available to active traders is exchange-traded funds (ETFs). These securities are still “newbies” by market standards, but they have exploded in number and coverage in the market.

ETFs are very much like mutual funds in that they track a basket of assets that mimics an index, stock sector, commodity, or some other logical grouping of assets. The first ETF tracked the S&P 500 index. Unlike mutual funds, ETFs trade on stock exchanges as stocks do with continual pricing. Traders can use the same trading strategies with ETFs that they use with stocks—selling short, buying on margin, and so on.

Because of their structure, ETFs are often more efficient than mutual funds. You get the diversification of mutual funds with greater efficiency and the ease of trading stocks. Many of the ETFs cover broad sections of the market via indexes. Almost every stock index is covered by an ETF.

While active traders may not find broad index coverage especially beneficial, ETFs are also available for a variety of industry sectors. These sector ETFs can be used with individual stocks to structure arbitrage trades and for swing and position traders who want to follow hot (or cold) sectors. There are even ETFs that cover segments of foreign markets. The importance of opportunities in the global economy should not be overlooked. You have hundreds of ETFs available to you.

Although you will see lower expense ratios with ETFs compared to most mutual funds, you buy and sell them as you would stocks, so be prepared to pay a commission both ways. See Chapter 8 for more on ETFs.

Options offer active traders several opportunities depending on whether you are a short-term trader or take a longer view as swing and position traders do. It is the same security, but used in different ways for different trading goals. Before you attempt to trade options or use them in your trading strategy, you should become very familiar with their characteristics and features. We’ll go into more detail in Chapter 9 on how they work and how active traders use them.

Options are contracts that give the owner the right, but not the obligation, to buy or sell a security at a set price within a defined time frame. The value of the option is tied to the underlying asset and the amount of time left before it expires. Breaking down the key points of options, there are several important considerations.

The owner of an option has the right, but not the obligation, to buy or sell (depending on the type of option) the underlying asset. The owner doesn’t have to do anything. If the option reaches its expiration date and the owner has not done anything, it simply goes away and the owner is out the premium he paid.

Unlike stocks, which have no end date, options have an expiration date. If the owner has not exercised her rights or sold the option by that date, the option ceases to exist. All options expire on the third Friday of the month.

The option gives the owner the right to buy or sell (depending on the type of option) the asset at a fixed price or strike price. Regardless of what happens to the price of the underlying asset, the option price of the asset remains the same. If you have an option to buy a stock at $10 per share and the stock rises to $15 per share before the option expires, you have a built-in profit of $5 per share.

Most option contracts are sold for a profit rather than exercising them and then selling the stock for a profit (you pay tax on two profits). The value of the option depends on the underlying asset. If the value of the underlying asset is such that your option is profitable, the value (price) of your option increases. You can sell the option at a profit. Pricing options is complicated by the amount of time remaining before expiration.

Options come in two varieties: call options give you the right to buy an underlying option; put options give you the right to sell an underlying option. It is easy to see that if you believe the asset is going to increase in value, you would buy a call option. If you believe the asset is going to decline in value, you would buy a put option.

Why not buy the asset or sell it short rather than use options? One of the main reasons is margin. Options have tremendous margin built into them because you can control a large block of stock for a fraction of the cost of buying it outright. Option contracts are sold in 100-share lots. You can buy an option on 100 shares of stock for a few dollars per share, called an option premium. For example, you might be able to buy a call option contract for 100 shares of a stock selling at $15 per share for $200, depending on the option characteristics. Rather than buy the stock for $1,500 or even $750, if you margined the trade, you are in for $200.

Options trade on exchanges just as stocks and bonds do and most brokerages will let you trade them through your account, although you may have to fill out extra paperwork. Options are considered risky because they have expiration dates and you can lose all of your money.

So far, our discussion of options has been about buyers, but you can also be a seller of options. Under these circumstances, you receive the option premium when the option is bought (less fees). However, unlike the buyer, you are obligated to fulfill the terms of the option contract. For example, if you sell a call option for a stock with a strike price of $15 per share, you are obligated to sell 100 shares of the stock at $15 per share to the holder of the call option. Likewise, if you sell a put option at $15 per share, you are obligated to buy the stock at $15 per share. We’ll discuss these obligations and trading strategies in more detail in Chapter 9.

A futures contract is another derivative that active traders can use to great advantage—although at some risk. A futures contract, unlike the option contract, obligates you to buy a commodity or financial instrument at a future date for a specific price. Active traders can use futures contracts and variations to help them react to different market and currency conditions. Like options, futures are not for beginners. They are even more risky than options because the amount of leverage is huge and it is possible to lose more money than your initial investment.

Not everyone who uses futures contracts is a trader. The securities were created as a way to hedge risk for producers and consumers of commodities such as wheat, beef, and precious metals. Producers can use futures contracts to lock in a price for their products before they are produced (a future grain crop, for example). Consumers, such as food processors, can also use futures to lock in prices so they will know future costs of raw material (grain, for example).

Trading futures can be very profitable because of the huge leverage involved. Most exchanges require a 5 to 10 percent deposit to control a futures contract. A few thousand dollars deposit can control $75,000 of an asset. Because of this huge leverage, a small change in price up or down means a big gain or loss for the investor.

The real danger for traders is that the exchanges where futures contracts trade set daily limits on price changes. These limits prevent the price from rising or falling too rapidly. If a futures contract hits an upper or lower limit during the trading day, the exchange halts trading for the day. When trading resumes the next day, new limits are in place. What this means for traders is that it may be difficult to get out of a position quickly if the market is falling rapidly, for example. We’ll look at more features of futures trading in Chapter 9.

The last wide-open frontier of trading is on the foreign exchange or forex where trillions of dollars in world currencies trade every day in an unregulated market. You can’t go on any financial website without seeing ads for brokers wanting your forex business. The market for trading currency (U.S. dollars for Japanese yen, for example) is open six days a week, 24 hours a day.

Like other forms of trading, you look for bargains by buying one currency while selling another. Contracts are settled in cash with profits and losses on each trade going into your account. The leverage is huge with deposits of 10 percent per contract typical. This has allowed average traders to participate in this fast-moving but very risky market. The factors that change currency relationships are complex and not always transparent. We’ll look at forex trading in detail in Chapter 9.

The Least You Need to Know