Chapter 5
IN THIS CHAPTER
Making money with other people’s money
Garnering tall profits from short sales
Using leverage in every market you can imagine
Borrowing for business and personal needs
Considering the consequences of leverage
In a certain sense, day trading isn’t risky at all. Day traders close out their positions overnight to minimize the possibility of something going wrong while the trader isn’t paying attention. Each trade is based on finding a small price change in the market over a short period of time, so nothing is likely to change dramatically. But here’s the thing: Trading this way leads to small returns. Trading full time is hard to justify if you aren’t making a lot of money when you do it, no matter how low your risk is.
And some days, there aren’t many good trades to make. You may be looking for securities to go up, but they don’t. Zero trades lead to zero risk — and zero return. For this reason, savvy traders think about other ways to make money on their trades, even when doing so involves taking on more risk. That risk is what generates the return that many traders crave.
In this chapter, I cover two techniques for finding trades and increasing returns: short selling and leverage. Both involve borrowing, and both increase risk. They’re common to day trading, and other market participants as well use them, so the rules and procedures are set.
The dollars you make from trading depend on two things: your percentage return on your trades and the dollars you have to start out with. If you double your money but have only a $1,000 account, you’re left with $2,000. If you get a 10 percent return but have a $1,000,000 account, you make $100,000. Which would you rather have? (Yes, I know, you’d rather double your money with the $1,000,000 account. But I didn’t give you that choice, alas.)
The point is that the more money you have to trade, the more dollars you can generate, even if the return on the trade itself is small. If you have $500,000 and borrow $500,000 more, then your 10 percent return gives you $100,000 to take home, not $50,000. You’ve doubled the dollars returned to you by doubling the money you used to place the trades, not by doubling the performance of the trade itself. Clever, huh?
Day traders and other short-term traders aren’t looking to make big money on any single trade. Instead, the goal is to make small money on a whole bunch of trades. Unfortunately, all those little trades don’t easily add up to something big. That’s why many day traders turn to leverage. They either borrow money or stock from their brokerage firm or they trade securities that have built-in leverage, such as futures and foreign exchange.
Leverage not only adds risk to your own account but also adds risk to the entire financial system. If everyone borrowed money and then some big market catastrophe happened, no one would be able to repay their loans, and the people who lent the money would go bust, too.
As a result, an incredible amount of oversight goes with leverage strategies. The Securities and Exchange Commission, the Commodity Futures Trading Commission, the different exchanges, and even the U.S. Treasury Department regulate how much money a trader can borrow. Many brokerage firms have even stricter rules in place as part of their risk management, and they’re expected to demonstrate to FINRA and the National Futures Association that they follow their practices.
This extensive oversight means that you have about as much flexibility when you borrow from your broker to buy and sell securities as you would have if you borrowed from your friendly neighborhood loan shark to play a high-stakes poker game. In other words, not much.
Margin loans, which are loans from your broker that increase your buying power, are highly regulated, and you must meet the broker’s terms. If you fail to repay the loan, your positions will be sold from underneath you. If you try to borrow too much, you will be cut off. No amount of begging and pleading will help you.
Your brokerage firm makes you sign a margin agreement, which says that you understand the risks and limits of your activities. You probably can’t have a margin account unless you meet a minimum account size, maybe $10,000 or more, and the amount you can borrow depends on the size of your account. Generally, a stock or bond account must hold 50 percent of the purchase price of securities when you borrow the money. The price of those securities can go down, but if they go down so much that the account ends up holding only 25 percent of the value of the loan, you get a margin call. (Some brokers call in loans faster than others; their policies are disclosed in their margin agreements.)
Every brokerage firm charges interest on margin. The stated number is usually an annualized rate; if the rate given is 8 percent, for example, then you’d owe that much if your loan was outstanding for the entire year. (Some investors have margin loans in place that long.) A day trader, whose loan may only be outstanding for a few hours, probably has to pay interest, too. Some brokerage firms charge by the day; others may charge interest over three days because it takes three days for a trade to settle.
The interest rate that a brokerage firm charges varies over time. Many firms tie their margin rate to an underlying rate of interest in the broader market, such as Libor (the London Interbank Offering Rate, or what international banks charge each other for loans), the prime rate (the rate that U.S. banks charge their best customers for loans), or another rate that is quoted in the financial markets. In fact, these rates are often used as the margin rates that the major banks charge their best and largest trading customers.
If you’re a day trader with a few thousand dollars on account instead of a global bank’s proprietary trading desk with a few billion, you’ll pay a markup to the basic margin rate. These rates will fluctuate with the market rate of interest, so if interest rates go up in the economy as a whole, they’ll increase for day traders, too.
In addition to margin interest, some firms charge a higher commission on margin trades than for cash trades. They justify this policy with the higher levels of paperwork and risk management required on margin accounts. Some firms go with the higher commission rather than charge interest on intraday loans. Your trading life will be easier if you find out your firm’s policies and fees before you open a margin account.
If you trade derivatives, margin works differently. Futures and options contracts themselves are leveraged, so you aren’t charged interest. You have to settle your profits and losses at the end of the day, however (don’t worry; the exchange’s clearinghouse does it for you). You can’t use the money held as margin for other trades. At some exchanges, margin is known as a performance bond.
Derivatives traders neither pay nor receive interest on the amount in their margin accounts because the market interest rate is included in the value of the option or the future.
If the value of your account starts falling and it looks like it’s falling below the 25 percent maintenance margin limit, you get a margin call, in which your broker calls you and asks you to deposit more money in your account. If you can’t make the necessary deposit, the broker starts selling your securities to close out the loan. And if you don’t have enough to pay off the loan, the broker closes your account and puts a lien, which is a claim on your assets, against you.
At least one brokerage firm advertises that, as a service to you, it will close out your account as soon as you lose the amount in it in order to keep you from losing more money. This service helps the brokerage firm as much as it helps you, because it keeps the firm from dealing with the hassles of chasing down additional margin. This is one example of the built-in risk management policies that firms use to limit risks to everyone.
Day traders are often able to avoid margin calls because they borrow money for such short periods of time. Good day traders look for small market moves and cut their losses early, which minimizes the risk of using other people’s money. And by definition, day traders close out their positions every night.
If you qualify as a pattern day trader, you get two benefits. First, your brokerage firm probably won’t charge you any interest as long as you don’t hold a margin loan balance overnight. Second, you may be allowed to borrow more than 50 percent of the purchase price of securities. Some firms allow pattern day traders to borrow 75 percent or more of their trade value.
Traditionally, investors and traders want to buy low and sell high. They buy a position in a security and then wait for the price to go up. This strategy isn’t a bad way to make money, especially because, if the country’s economy continues to grow even a little bit, businesses are going to grow and so are their stocks.
But even in a good economy, some securities go down. The company may be mismanaged, it may sell a product that’s out of favor, or maybe it’s just having a string of bad days. For that matter, maybe it went up a little too much in price, and investors are now coming to their senses. In these situations, you can’t make money buying low and selling high. Instead, you need a way to reverse the situation.
The solution? Selling short. In short — ha! — selling short means that you borrow a security and sell it in hopes of repaying the loan of the shares by buying back cheaper shares later on.
Most brokerage firms make selling short easy. You simply place an order to sell the stock, and the broker asks whether you’re selling shares that you own or selling short. After you place the order, the brokerage firm goes about borrowing shares for you to sell. It loans the shares to your account and executes the sell order.
When the shares are sold, you wait until the security goes down in price, and then you buy the shares in the market at a bargain. You then return these purchased shares to the broker to pay the loan, and you keep the difference between where you sold and where you bought — less interest, of course.
You can earn interest on the money you receive for selling the stock, and investors who are active on the short side of the market figure this into their returns. However, day traders don’t hold on to their positions long enough to earn interest.
Figure 5-1 shows how short selling works. The trader borrows 400 shares selling at $25 each and then sells them. If the stock goes down, she can buy back the shares at the lower price, making a tidy profit. If the stock stays flat, she loses money because the broker will charge her interest based on the value of the shares she borrowed. And if the stock price goes up, she not only loses money on the interest expense but also is out on her investment.
Investors — those people who do careful research and expect to be in their positions for months or even years — look for companies that have inflated expectations and are possibly fraudulent. Investors who work the short side of the market spend hours doing careful accounting research, looking for companies that are likely to go down in price some day.
Day traders don’t care about accounting. They don’t have the time to wait for a short to work out. Instead, they look for stocks that go down in price for more mundane reasons, like more sellers than buyers in the next ten minutes. Most day traders who sell short simply reverse their long strategy. For example, some day traders like to buy stocks that have gone down for three days in a row, figuring that they’ll go up on the fourth day. They’ll also short stocks that have gone up three days in a row, figuring that they’ll go down on the fourth day. You don’t need a CPA to do that!
Trading strategies are covered in more detail in Chapters 9 and 10, if you are looking for some ideas.
Shorting stocks carries certain risks because a short sale is a bet on things going wrong. Because, in theory, there’s no limit on how much a stock can go up, there’s no limit on how much money a short seller can lose. Two traps in particular can get a short seller. The first is a short squeeze due to good news; the second is a concerted effort to hurt traders who are short.
With a short squeeze, a company that has been popular with a lot of short sellers has some good news that drives the stock price up. Or, maybe some other buyers simply drive up the price in order to force the shorts to sell, which is a common form of market manipulation. When the price goes up, short sellers lose money, and some may even have margin problems. And the original reason for going short may be proven to be wrong. Those who are short start buying the stock back to reduce their losses, but their increased demand drives the stock price even higher, causing even bigger losses for people who are still short. Ouch!
All is not sweetness and light in the world of short selling. Many market participants distrust those folks who are doing all the careful research, in part because they are often right. Company executives are often optimists who don’t like to hear bad news, and they blame short sellers for all that is wrong with their stock price. Meanwhile, some short sellers have been known to get impatient and start spreading ugly rumors if their sale isn’t making money.
Many companies, brokers, and investors hate short sellers and try tactics to bust them. Sometimes they issue good news or spread rumors of good news to create a squeeze. Other times, they collectively ask holders of the stock to request that their brokerage firm not loan out their shares, which means that those who shorted the stock have to buy back and return the shares even if doing so makes no sense.
Leverage is the use of borrowed money to increase returns. Day traders use leverage a lot to get bigger returns from relatively small price changes in the underlying securities. And as long as they consistently close their positions out at the end of the day, day traders can borrow more money and pay less interest than people who hold securities for a longer term.
The process of borrowing works differently in different markets. In the stock and bond markets, it’s straightforward: When you place the order, you just tell your broker you’re borrowing. In the options and futures markets, the contracts you buy and sell have leverage built in to them. Although you don’t borrow money outright, you can control a lot of value in your account for relatively little money down. The following sections go into more detail on these points.
Leverage is straightforward for buyers of stocks and bonds: You simply click the box marked “Margin” when you place your order, and the brokerage firm loans you money. Then when the security goes up in price, you get a greater percentage return because you’ve been able to buy more for your money. Of course, that also increases your potential losses. (For more detail on the margin process, head to the earlier section “Understanding the Magic of Margin.”)
Figure 5-2 shows how leverage works. The trader borrows money to buy 400 shares of SuperCorp. If the stock goes up 4 percent, she makes 8 percent. Whoo-hooo! But if the stock goes down 4 percent, she still has to repay the loan at full dollar value, so she ends up losing 8 percent. That’s not so good.
An option gives you the right, but not the obligation, to buy or sell a stock or other item at a set price when the contract expires. A call option gives you the right to buy, so you would buy a call if you think the underlying asset is going up. A put option gives you the right to sell, so you would buy a put if you think the underlying asset is going down. (You can read more about options in Chapter 4.) By trading an option, you get exposure to changes in the price of the underlying security without actually buying the security itself. That’s the source of the leverage in the market.
A day trader can use options to get an exposure to price changes in a stock for a lot less money than buying the stock itself would cost. Suppose a call option is deeply in the money, meaning that its strike price (the price at which you would buy the stock if you exercised the option) is far below the current stock price. In this event, the obvious thing to do is to set option price at the difference between the current stock price and the strike price, which is more or less what happens — more in theory, less in practice. When the stock price changes, the option price changes by almost exactly the same amount, enabling you to buy the price performance of the stock at a discount, with the discount being the strike price of the option.
Figure 5-3 shows the performance-boosting leverage from this strategy. The trader buys call options with an exercise price of $10 on a stock trading at $25. The option price changes the same amount that the stock price does, but the call holder gets a greater percentage return than the stockholder.
Day traders can use many other options strategies, but a discussion of them goes beyond the scope of this book. The appendix has some resources to help you in your research.
A futures contract gives you the obligation to buy or sell an underlying financial or agricultural commodity, assuming you still hold the contract at the expiration date. That underlying product ranges from the value of treasury bonds to barrels of oil and heads of cattle, and you’re only putting money down now when you purchase the contract. You don’t have to come up with the full amount until the contract comes due — and almost all options and futures traders close out their trades long before the contract expiration date. Futures are discussed in Chapter 4, but here I talk about how leverage works in the futures market.
Because derivatives have built-in leverage that allows a trader to have big market exposure for relatively few dollars up front, they’ve become popular with day traders. Figure 5-4 shows how derivative leverage works. Here, a trader is buying the Chicago Mercantile Exchange’s E-mini S&P 500 futures contract, which gives her exposure to the performance of the Standard and Poor’s 500 Index, a standard measure of the stock performance of a diversified list of 500 large American companies. The futures contract trades at 50 times the value of the index, rounded to the nearest $0.25. The minimum margin that this trader must put down on the contract is $3,500. Each $0.25 change in the index leads to a $12.50 ($0.25 × 50) change in the value of the contract, and that $12.50 is added to or subtracted from the $3,500 margin.
The foreign exchange, or forex, market is driven by leverage. Despite the nervous reports you may hear in the financial news, exchange rates tend to move slowly, by as little as a tenth or even a hundredth of a penny a day. And the markets are so huge that hedging risk is easier in the currency markets than in other financial markets. You may have trouble borrowing shares of stock that you want to short, but you should have no trouble ever borrowing yen. To get a big return, forex traders almost always borrow huge amounts of money.
In the stock market, day traders can borrow up to three times the amount of cash and securities held in their accounts (although not all firms let you borrow the statutory maximum), and that amount is set by outside regulatory organizations. In the forex market, there is no regulation on lending, and some forex firms allow traders to borrow as much as 400 times the amount in their accounts.
Forex firms allow such huge borrowing because they can hedge their risks so that if you lose money, they make money. If you sell dollars to buy euros, for example, the firm can easily go in and sell euros to buy dollars. This capability makes its position net neutral. If the euro goes down relative to the dollar, you lose money, but the firm can offset its risk because its counter-trade went up. And, of course, the firm is receiving interest for the margin that you’re using.
Figure 5-5 shows how leverage in foreign exchange makes good returns possible. Here, the trader starts with a $1,000 account and borrows the maximum amount the forex firms allow, $400 for each dollar in the account. All $401,000 are put to work buying euros. Note that the euro value stays constant, but the dollar value of those euros changes by hundredths of a penny. Thanks to leverage, the return is 11 percent — not bad for a day’s trading! Of course, you could lose 11 percent, which wouldn’t be so good.
Leverage is only part of the borrowing involved in your day trading business. Like any business owner, sometimes you need more cash than your business generates. Other times, you see expansion opportunities that require more money than you have on hand. In this section, I discuss why and how day traders can borrow money over and above leveraged trading.
If day trading is your job, then you face a constant pressure: How do you cover the costs of living while keeping enough money in the market to trade? One way to do so is to have another source of income — from savings, a spouse, or a job that doesn’t overlap with market hours. Other day traders take money out of their trading account.
If the market hasn’t been cooperative, your account may not have enough in it to allow you to withdraw funds while still maintaining enough capital to trade. One option is to arrange a margin loan through a brokerage firm. With a margin loan, the firm lets you take out a loan against the cash in your account (or securities that you are holding, not trading). You can spend the money any way you like, but you’re charged interest and you have to repay it. Still, a margin loan is a good option to know about because day-trade earnings tend to be erratic.
Some day traders use a double layer of leverage: They borrow the money to set up their trading accounts and then they borrow money for their trading strategies. If the market cooperates, this type of borrowing can be a great way to make money, but if the market doesn’t cooperate, you could end up owing a lot of people money that you don’t have.
If you want to take the risk, though, you have a few resources to turn to other than your relatives: You can borrow against your house, use your credit cards, or find a trading firm that will give you some money to work with.
Yes, you can use a mortgage or a home equity line of credit to get the money for your day trading activities. In general, this option carries low interest rates because your house is your collateral. In most cases, however, the interest isn’t tax deductible (ask your accountant, but generally, you can only deduct interest used to purchase or improve your house). Still, borrowing against your house can be a relatively low-cost way to pull value stored in your house for use in trading.
The business world is filled with people who started businesses using credit cards. And you can do that. If you have good credit, credit card companies are happy to lend to you.
Some firms that are in the business of trading are willing to stake new traders. You may have to go through a training period or pay a fee to rent a desk at their office or to use their software remotely. The firm watches your trading patterns, including both your profits and your risk management. If the principals like what they see, they may offer you money to manage along with your own capital. You will receive a cut of the profits on the funds you trade for them.
Some traders figure that they don’t need margin accounts if they buy a security in a cash account and then sell it before they have to pay for it. This is known as free riding, and the SEC doesn’t look kindly upon it. In fact, brokerage firms are required to freeze a customer’s account for 90 days when they identify free riding. The customer can then trade only if he or she pays for each trade as it is made rather than receiving the three days normally allowed.
If you’re trading in a cash account, you can avoid having the assets frozen due to suspected free riding by paying for any securities that you buy within three days, without relying on money from the sale of those securities to cover the payment. The alternative is to trade in a margin account.
Leverage introduces risk to your day trading, and that can give you greatly increased returns. Most day traders use leverage, at least part of the time, to make their trading activities pay off in cold, hard cash. The challenge is to use leverage responsibly. Chapter 6 goes into money management in great detail, but here I cover the two issues most related to leverage: losing your money and losing your nerve. Understanding those risks can help you determine how much leverage you should take and how often you can take it.
Losing money is an obvious hazard. Leverage magnifies your returns, but it also magnifies your risks. Any borrowings have to be repaid regardless. If you buy or sell a futures or options contract, you are legally obligated to perform, even if you have lost money. That can be really hard.
The basic risk and return of your underlying strategy isn’t affected by leverage. If you expect that your system will work about 60 percent of the time, that should hold no matter how much money is at stake or where that money came from. However, trading with borrowed money likely does make a difference to you on some subconscious level.