Looking for liquidity

Liquidity is the ability to buy or sell an asset in large quantity without affecting the price levels. Day traders look for liquid assets so they can move in and out of the market quickly without disrupting price levels. Otherwise, they may not be able to buy at a good price or sell when they want.

At the most basic level, financial markets are driven by supply and demand. The more of an asset supplied in the market, the lower the price; the more of an asset that people demand, the higher the price. In a perfect market, the amount of supply and demand is matched so that prices don’t change. This situation occurs if a high volume of people are trading such that the supply and demand are constantly matched or if the frequency of trades is very low, which keeps the price from changing.

You may be thinking, “Wait, don’t I want big price changes so that I can make money quickly?” Yes, you want price changes in the market, but you don’t want to be the one causing them. The less liquid a market is, the more likely your buying and selling are to affect market prices, and the smaller your profit will be.

Homing in on high volatility

The volatility of a security is how much the price of an asset varies over a period of time. It tells you how much prices fluctuate and thus how likely you are to be able to take advantage of that. For example, if a security has an average price of $5 but trades anywhere between $1 and $14, it is more volatile than one with an average price of $5 that trades between $4 and $6.

One standard measure of volatility and risk is standard deviation, which is how much any given price quote varies from a security’s average price. If you are dying to see it, the math is explained in the sidebar “Finding the standard deviation — the hard way,” but you can calculate it with most spreadsheet programs and many trading platforms.

The higher the standard deviation, the higher the volatility; the higher the volatility, the more a security’s price is going to fluctuate, and the more profit — and loss — opportunities there are for a day trader.

Standard deviation is also a measure of risk that can be used to evaluate your trading performance. That use of the measure is discussed in Chapter 16.

Staying within your budget

You don’t necessarily need a lot of money to begin day trading, but you do need a lot of money to buy certain securities. Stocks generally trade in round lots, which are orders of at least 100 shares. If you want to buy a stock worth $40 per share, you need $4,000 in your account. Your broker will probably let you borrow half of that money, but you still need to come up with the other $2,000.

Options and futures trade by contract; one contract represents some unit of the underlying security. For example, in the options market, one contract is good for 100 shares of the stock. It’s possible to trade only one contract, but the most traders work in round lots of 100 contracts per order.

No one will stop you from buying a smaller amount than the usual round lot in any given security, but you’ll probably pay a high commission and get worse execution for your order. Because the returns on each trade tend to be small anyway, don’t take up day trading until you have enough money to trade your target asset effectively. Otherwise, you’ll pay too much to your broker without getting much for yourself.

Bonds don’t trade in fractional amounts; they trade on a per-bond basis, and each bond has a face value of $1,000. Some trade for more or less than that, depending on how the bond’s interest rate differs from the market rate of interest, but the $1,000 figure is a good number to keep in mind when thinking about capital requirements. Many dealers have a minimum order of ten bonds, though, so a minimum order would be $10,000.

Making sure you can use margin

Most day traders make money through a large volume of small profits. One way to increase the profit per trade is to use borrowed money to buy more shares, more contracts, or more bonds. Margin is money in your account that you borrow against, and almost all brokers will be happy to arrange a margin loan for you, especially if you’re going to use the money to make more trades and generate more commissions for the brokerage firm. In Chapter 5, I discuss how margin is used within an investment strategy. Here, though, you want to think about how margin affects your choice of assets for day trading.

The following section gives you more information on how margin works and what you need to consider when selecting assets to trade, but here’s what you need to know now: Most stocks and bonds are marginable (able to be purchased on margin), and the Federal Reserve Board allows traders to borrow up to 50 percent of their value. But not all securities are marginable. Stocks priced below $3 per share, those traded on the OTC Bulletin Board or OTC Link (discussed later in this chapter), and those in newly public companies often cannot be borrowed against or purchased on margin. Your brokerage firm should have a list of securities that are not eligible for margin.

If leverage is going to be part of your day trading strategy, be sure that the assets you plan to trade are marginable.

Generally, your stock or bond account must hold the greater of $2,000 or 50 percent of the purchase price of securities when you borrow the money. So, for example, if you want to buy $5,000 worth of something on margin, you need to have $2,500 in your account. The price of those securities can go down, but if they go down so much that the account now holds only 25 percent of the value of the loan, you’ll get a margin call. That means that you have to add cash or securities to your account right then and there. If not, your position will be liquidated.

Excess margin is the amount of money in your account over and above the minimum. For example, if you have $100,000 in your account and need 30 percent as maintenance margin, then you can borrow against an additional $70,000, the amount in excess of the 30 percent used for maintenance.

For derivatives, the margin rules are a bit different. Each contract has its own requirement for the initial margin and maintenance levels that must be kept on account; in the argot of the derivatives markets, margin is also known as a performance bond. If you are trading the Chicago Mercantile Exchange’s E-mini MSCI Emerging Markets index contracts, for example, your initial margin per contract is $10,000, and your maintenance margin is $8,000. You can find current margin requirements for Chicago Mercantile Exchange and Chicago Board of Trade products at the Chicago Mercantile Exchange’s website, www.cmegroup.com.

Margin requirements aren’t set by the brokerage firms. Instead, the minimum amount in your account — and thus the maximum amount you can borrow — is set by the Federal Reserve Board under Regulation T. That’s because of concerns that if too much borrowing takes place, the borrowers will panic in a financial downturn and drag the market down even further. (Excessive trading on margin was a contributing factor to the stock market crash of 1929, in which the Dow Jones Industrial Average fell 13 percent in one day, and the market did not fully recover until 1954. The financial crisis of 2008 wasn’t caused by leverage in the stock market but by excessive borrowing in the real estate market.)

How U.S. stocks trade

Stocks are priced based on a single share, but most brokerage firms charge commissions based on a 100-share basis because stocks are almost always traded in round lots of 100 shares. The supply and demand for a given stock is driven by the company’s expected performance.

A stock’s price is quoted with a bid and an ask.

• The bid is the price that the broker pays to buy the stock from you if you are selling.
• The ask is the price that the broker charges you if you are the one buying.

You can remember the difference between the bid and the ask this way: The broker buys on the bid. Let alliteration be your friend! The difference between the bid and the ask is the spread, and that represents the dealer’s profit.

Here is an example of a price quote:

AMZN $1971.72 $1972.45

This quote is for Amazon (ticker symbol: AMZN). The bid, listed first, is $1971.72, and the ask is $1972.45. The spread is $0.73. (The smallest possible spread is just one penny.) The spread here is small as a percentage of the total price because Amazon is a liquid stock, and no big news events were happening at this time to change the balance of buyers and sellers.

The brokerage firm makes money from the commission and from the spread. Many novice day traders focus on the amount of the commission and forget that some brokerage firms can execute the order better than others, thus keeping the spread narrower. You need to consider the total cost of trading when you design a trading strategy and choose a brokerage firm, and brokers must disclose data on trade execution quality if you request it.

I tend to use the words broker and dealer interchangeably, but there is a difference. A broker simply matches buyers and sellers of securities, whereas a dealer buys and sells securities out of its own account. Almost all brokerage firms are both brokers and dealers.

Where U.S. stocks trade

I provide detailed discussion of financial markets in Chapter 2. Here, I examine some specifics for the stock market. In particular, most U.S. stocks trade on organized exchanges such as the New York Stock Exchange and Nasdaq, but they trade more and more on electronic communications networks, some of which are operated by the exchanges themselves.

The old-line exchanges are what you may think about when someone mentions stock exchanges: brick-and-mortar buildings with lots of people running around to execute trades in person. They are still major factors in the market, but they have competition from electronic communication networks, which were created with the theory being that more competition would make markets function even better. It hasn’t quite worked out that way. Spreads between bid and ask prices have narrowed, but volatility has increased since they became a factor in the market. On the other hand, volatility creates opportunity for day traders, so that’s not necessarily a bad thing.

When you place an order with your brokerage firm, the broker’s computer executes that order wherever it can get the best deal. But is that the best deal for you or the best deal for the brokerage firm? It’s tough to know the right answer. In general, firms that do more trading and participate in several exchanges and electronic communications networks can get you the best execution. (To find out more about choosing brokerage firms, turn to Chapter 15.)

The financial markets are in a state of flux, with a lot of mergers and acquisitions among the exchanges. By the time you read the information here, things may have changed again, which I think is fascinating. It wasn’t so long ago that these exchanges were staid organizations run like private clubs.

Alternative exchanges

Nasdaq was the first electronic stock exchange, but it’s now an institution. Several new exchanges have emerged to compete with the NYSE and Nasdaq. These often started as electronic communications networks (also known as ECNs). These are groups of brokerage firms and investing companies that agree to trade among each other before putting the order out to another exchange, but they’ve grown enough to become something else. They have created new trading opportunities and reduced costs, but they’ve also added to the volatility in the market.

As a result, you may see that your trade has been executed through ARCA, BYX, BZX, Edgx, IntercontinentalExchange, or any of the other exchanges that have cropped up over the years. Many of these exchanges are designed to match one order with another automatically. If you have 100 shares of something to sell and someone else wants to buy 100 shares, your orders are matched and cleared. Trades that take place on these exchanges generally do so at smaller spreads and lower fees than trades on traditional exchanges, but fewer trades take place on them.

In any event, a broker that works closely with ECNs and alternative exchanges may be able to get you a better deal, which is important because in trading very small price differences add up.

The high-risk over-the-counter exchanges

When the traditional floor-based exchanges were the primary game, a few companies emerged to trade stocks that were not eligible for exchange listing. These businesses are still around, and many traders like them because they can find stocks that have good volatility that are too small to attract the attention of the big guys with their big computers. However, the risk level is a lot higher: Some of these stocks don’t trade enough for a day trader, and a few of these stocks aren’t issued by legitimate companies.

Dark pools

Don’t be put off by the word dark — dark pools, also known as dark liquidity, are good for traders. These exchanges allow people to place buy and sell orders that will be executed only if someone takes the other side. Of course, that’s how most markets operate, but dark pools don’t publish the prices or the sizes of the orders. Traders use them for low-cost execution, not price discovery. The downside is that price listings carry information about where the market is headed. If you’re interested in reading more, check out Dark Pools & High Frequency Trading For Dummies by Jay Vaananen (John Wiley & Sons, Inc.) for more information.

How bonds trade

Bonds often trade as single bonds, with a face value of $1,000, although some brokers take on only minimum orders of ten bonds. Bonds do not trade as frequently as stocks do because most bond investors are looking for steady income, so they hold their bonds until maturity. Bonds have less risk than stocks, so they show less price volatility. The value of a bond is mostly determined by the level of interest rates in the economy. As rates go up, bond prices go down; when rates go down, bond prices go up. Bond prices are also affected by how likely the loan is to be repaid. If traders don’t think that the bond issuer will pay up, then the bond price will fall.

Generally speaking, only corporate and municipal bonds have repayment risk. The U.S. government could default, but that scenario is unlikely as long as the government can print money. Most international government bonds have similarly low default risk, but some countries have defaulted. The most notable was Russia, which refused to print money to repay its debts in the summer of 1998 — a decision that caused huge turmoil in the world’s financial markets, including the collapse of a major hedge fund, Long-Term Capital Management.

Investment banks and the federal government sell new bonds directly to investors. After they are issued, bonds are said to trade in the secondary market; some are listed, and some trade over-the-counter, meaning dealers trade them among themselves rather than over an organized exchange.

A bond price quote looks like this:

2.250 4/30/2021 n 98:6016 98:6125

Translation: This bond is a U.S. Treasury note maturing in on April 30, 2021 and carrying an interest rate of 2.250 percent. Similar to stocks, the numbers right after the n (for note) list the bid and ask. The first number is the bid, the price that the dealer pays to buy the bond from you if you are selling. The second number is the ask, the price that the dealer charges you if you’re buying. The difference is the spread, and that’s the dealer’s profit.

Listed bonds

Some larger corporate bonds are traded on the New York Stock Exchange. Those wanting to buy or sell them place an order through their brokerage firm, which sends an order to the floor broker. The process is almost identical to the trading of listed stocks.

Over-the-counter trading

Most corporate and municipal bonds trade over-the-counter, meaning no organized exchange exists. Instead, brokerage firms use electronic price services to find out where the buyers and sellers are for different issues. Over-the-counter bonds don’t trade much. Buyers often give their quality, interest rate, and maturity requirements to their broker, and the broker waits until a suitable bond comes to market.

Treasury dealers

Unlike the corporate and municipal bond market, the Treasury market is one of the most liquid in the world. The best way to buy a new Treasury bond is directly from the government because no commission is involved. You can get more information from the Treasury Department’s website, www.treasurydirect.gov; it has information on all kinds of government bonds for all kinds of purchasers.

After the bonds are issued, they trade on a secondary market of Treasury dealers. These are large brokerage firms registered with the government who agree to buy and sell bonds and maintain a stable market for the bonds. If your brokerage firm is not a Treasury dealer, it has a relationship with one that it can send your order to.

Treasury dealers do quite a bit of day trading in Treasury bonds for the firm’s own account. After all, the market is liquid enough that day trading is possible. Few individual day traders work the Treasury market, though, because it requires a great deal of capital and leverage to make a high return.

How currency trades

The exchange rate is the price of money. It tells you how many dollars it takes to buy yen, pounds, or euros. The price that people are willing to pay for a currency depends on the investment opportunities, business opportunities, and perceived safety in each nation. If American businesses see great opportunities in Thailand, for example, they have to trade their dollars for baht in order to pay rent, buy supplies, and hire workers there. This situation increases the demand for baht relative to the dollar and causes the baht to go up in price relative to the dollar.

Exchange rates are quoted on a bid-ask basis, just as bonds and stocks are. A quote may look like this:

USDJPY= 111.98 111.99

This is the exchange rate for converting the U.S. dollar into Japanese yen. The bid price of 11.98 is the amount of yen that a dealer would give you if you wanted to sell a dollar and buy yen. The ask price of 111.99 is the amount of yen the dealer would charge you if you wanted to buy a dollar and sell yen. The difference is the dealer’s profit, and naturally, you’ll be charged a commission, too.

Note that with currency, you’re a buyer and a seller at the same time, which can increase the profit opportunities, but it can also increase your risk.

Day traders can trade currencies directly at current exchange rates, which is known as trading in the spot market. When you exchange money to go on vacation in a foreign land, you are exchanging on the spot, and you are allowed to do it as a trader or as an investor. Day traders can also use currency exchange-traded funds (discussed earlier in this chapter) or currency futures (discussed later in this chapter) to profit from the changing prices of money.

Where currency trades

Spot currency — the real-time value of money — does not trade on an organized exchange. Instead, banks, brokerage firms, hedge funds, and currency dealers buy and sell amongst themselves all day, every day.

Day traders can open dedicated forex accounts through their brokers or currency dealers and then trade as they see opportunities during the day.

If you are interested in trading currencies, be sure to check out the fees involved. Some banks and brokerages are really set up to do forex trades for businesses and travelers, so the fees will be too high for you to have a decent profit potential. You can learn more about different types of accounts that day traders may have in Chapter 15.