Chapter 4
IN THIS CHAPTER
Expanding the pool of trading tools
Trading sector trends with ETFs
Inventing opportunities from invented money
Deriving profits from derivatives
Arbitraging your way to new opportunities
The basic financial assets — stocks, bonds, cash, and commodities — do a pretty good job of creating opportunities for people to hedge and speculate, but they have some limitations. The basic assets are just that: they’re securities that represent ownership in a business, a loan to a government or corporation, raw materials, or cold hard cash. They are nice, concrete, easy.
But they aren’t perfect. Nothing is, right? Some people wanted other ways to trade these assets, or parts of these assets, or hedge themselves against the financial risks that come with owning the underlying asset. The result of research, market demand, and more than a little financial engineering come the alternatives that I cover in this chapter.
These asset classes are particularly important for day traders. For example, although bonds play a huge role in the financial markets, they’re difficult for day traders to use. By trading interest rate futures or T-bill options, a trader can get exposure to the bond markets with smaller capital commitment and easier trading. Others of these assets, like cryptocurrencies, now exist mostly for the pleasure of traders but may become used like dollars and yen at some point in the future.
Some of these alternatives have greater liquidity than their counterpart in the traditional market, ’which is important for day traders. Others allow you to trade such narrow financial concepts as volatility or the future nature of money. As you get into them, you’ll find ideas for trading and a deeper understanding of the financial markets.
An exchange-traded fund (ETF) is a tradable security that represents a share in a collection of stocks, bonds, or other underlying securities.
In essence, ETFs are a cross between mutual funds and stocks, and they offer a great way for day traders to get exposure to market segments that may otherwise be difficult to trade. The category is sometimes called exchange-traded products because some of the funds are structured more as a trading strategy than as mutual funds.
To set up an ETF, a money-management firm buys a group of assets — stocks, bonds, or others — and then lists shares that trade on the market. In most cases, the purchased assets are designed to mimic the performance of an index, and investors know what those assets are before they purchase shares in the fund. The big advantage for day traders is that an ETF can be bought or sold at any time during the trading day, long or short, with cash or on margin, through a regular brokerage account. This flexibility is great for day traders.
Although an ETF looks a little bit like an index mutual fund or a market index futures contract, it has a very different structure. ETFs have two types of shares:
Most of the time, the price of both the creation units and the retail shares are right in-line with the price of the securities. On occasion, though, the value of the ETF and its investments will diverge. This usually happens at times of extreme market stress, so you may never see it. If you do, though, you may have an opportunity to make money.
ETFs have different investment styles that affect how they trade, and the next sections discuss how these work. Understanding the differences among ETFs can help you better target changing markets — and avoid making costly mistakes. You can find out more about the thousands of different ETFs on the market at www.morningstar.com/ETFs.html
.
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.
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.
An inverse ETF is designed to move the opposite of the underlying index. If the index is up, the inverse ETF should be down, and vice versa. An inverse ETF is useful as a way to speculate on a decline in the stock market or to remove the risk of the market from a portfolio (something that some hedge funds try to do).
A leveraged ETF is designed to return a multiple of the return on an index. A 5x ETF will return five times what the underlying index does, a groovy thing if the market is up 10 percent — and devastating if the market is down. A leveraged ETF is used to add risk to investment portfolios.
Some ETFs are designed to give stock traders a way to get exposure to commodities markets. These types of ETFs do this by investing in options and futures rather than stocks or bonds, which creates good trading opportunities, but it can also make for unusual trading trends.
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.
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.
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:
A currency — whether it be a U.S. dollar, a Canadian dollar, or a Mexican peso — is simply a tool that helps people make buy and sell goods and services. Governments (or groups of governments, in the case of the euro or the Central African CFA franc) issue currencies. As with any other asset, the value of a currency is determined by supply and demand.
The world’s currencies mostly work quite well, but the supply and demand can be, and often is, influenced by the political and economic decisions of a country’s leaders. For example, a country’s leaders may decide to pay off government debt by printing more money. This easy solution to one problem increases supply of the currency relative to demand, and so each unit of currency becomes worth less. At an extreme, you get extreme hyperinflation that destroys a currency and destabilizes a country, as has been experienced in Argentina, Venezuela, and Zimbabwe.
The problem of government officials undermining currency has led to all sorts of creative ideas for how to separate wealth and currency from any one country. The latest development, made in 2009, is Bitcoin, a digital currency that has been followed by many other digital currencies, also known as cryptocurrencies. These digital currencies have had wild price gyrations as people try to figure out what each cryptocurrency should be worth, and those price gyrations have attracted traders.
Here I discuss how cryptocurrencies work. After you have a better understanding of cryptocurrencies, you can determine if they are right for your trading strategies.
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.
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:
A fork is a change in the blockchain that starts a new series of blocks to record the transfer of a new set of coins. Programmers who hold the underlying coins develop forks, often to improve the way that the blockchain works. For example, Litecoin was forked from Bitcoin in order to set up a faster blockchain.
An initial coin offering (ICO) is a way that companies can raise money without issuing stock. Instead, they establish a blockchain and sell the coins that run on it. The idea is that the coins will become more valuable as the business takes off. In other cases, the coins being offered are designed to be used to buy the company’s goods or services once they come to market.
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.
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.
If most trade in cryptocurrency is due to the supply and demand of traders, then that’s the relevant factor in trading. The changes in supply and demand from all of the market’s traders show up in the charts. You don’t necessarily need to know the reason for the change to make a short-term profit from it.
Ultimately, then, cryptocurrencies trade based on technical analysis — and they will until it’s known for sure if there is any value to them in the rest of the economy.
The pump and dump is common in the crypto world just as it is in the world of penny stocks (refer to Chapter 3 for more information). This is the process of buying an asset, promoting it to others, and then selling it as the other buyers bid up the price. Pump and dump is illegal, but it isn’t always caught. People buy up a currency and then start to promote it on Reddit, YouTube, or other social media channel. When others start to buy the token, they turn around and sell it. Some scammers charge subscriptions to participate. With so many different types of cryptocurrency floating around and so little regulation around those who trade it, it’s no wonder that these things happen. I suggest that you don’t get involved with it because you may lose your money or even your freedom.
If you do decide to get cryptocurrency, follow these steps:
Get an account called a wallet.
A wallet is an account for holding and trading cryptocurrency. It gives you a number to use to record your transactions on the blockchain called an address. Bitcoin.org
, the website of a consortium of Bitcoin users, has a list of wallets at https://bitcoin.org/en/choose-your-wallet
. Different wallets have different security and transaction policies, so compare carefully. Some are free whereas others come with fees to download or to make transactions.
Although the blockchain can’t be hacked, wallets can be. Over the years, some wallet operators have lost clients’ coins due to mismanagement, and others have had customer accounts be stolen.
After you select your wallet, transfer cash from your bank account and use it to buy whatever cryptocurrency you want to own.
This process is known as a fiat exchange.
Cryptocurrencies, like all currencies, are traded over the counter rather than on an exchange. However, the brokers that handle cryptocurrency refer to themselves as cryptocurrency to cryptocurrency exchanges. They are software platforms that help you find others who are buying and selling the tokens in which you’re interested. They generally charge a percentage of the transaction as a fee.
You can trade cryptocurrency on traditional exchanges in different ways. Here are a few ways, with the easiest listed first:
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:
Derivatives are financial contracts that draw their value from the value of an underlying asset, security, or index. For example, an S&P 500 futures contract gives the buyer a cash payment based on the price of the S&P 500 index on the day that the contract expires. The contract’s value thus depends on where the index is trading. You’re not trading the index itself; instead, you’re trading a contract with a value derived from the price of the index. The index value changes all the time, so day traders have lots of opportunities to buy and sell.
Many day traders choose derivatives because these products give traders access to much of the economic universe, including stocks, bonds, commodities, and currencies. Furthermore, derivatives may have more favorable tax treatment for day traders than many other assets; more than one new day trader playing the stock market has been burned by the so-called wash-sale rule, which limits the deductibility of short-term losses. (I discuss this rule in Chapter 15.) Futures aren’t subject to wash-sale rules. Read on to find out more and see if they are right for you!
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.
An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon price at an agreed-upon date in the future. An option that gives you the right to buy is a call, and one that gives you the right to sell is a put. A call is most valuable if the stock price is going up, whereas a put has more value if the stock price is going down.
For example, a MSFT 2019 June 105 call gives you the right to buy Microsoft at $105.00 per share on the third Friday in June of 2019. If Microsoft is trading above $105.00, the option would be in the money. You could exercise the option and make a quick profit. If it is selling below $105.00, you could buy the stock cheaper in the open market, so the option would be worthless.
You can find great information on options, including online tutorials, at the Chicago Board Options Exchange website, www.cboe.com
.
Very few people who buy and sell options plan to hold them until expiration. They buy them either to speculate on price changes or to protect themselves against them. The price of an option depends on four things:
Traders are looking at these factors and buying puts and calls based on what they see in the short term. The relatively active trading and the leveraged exposure to the underlying asset make derivatives popular with day traders.
A futures contract gives you the obligation to buy a set quantity of the underlying asset at a set price and a set future date. Futures started in the agricultural industry because they allowed farmers and food processors to lock in their prices early in the growing season, reducing the amount of uncertainty in their businesses. Futures have now been applied to many different assets, ranging from pork bellies (which really do trade — they are used to make bacon) to currency values. A simple example is a lock in a home mortgage rate; the borrower knows the rate that will be applied before the sale is closed and the loan is finalized. Day traders use futures to trade commodities without having to handle the actual assets.
Most futures contracts are closed out with cash before the settlement date. Financial contracts — futures on currencies, interest rates, or market index values — can only be closed out with cash. Commodity contracts may be settled with the physical items, but almost all are settled with cash. No one hauls a side of beef onto the floor of the Chicago Board of Trade!
As with options, futures contracts have value to both hedgers and speculators. Most futures are closed out with an offsetting contract before the expiration date, and the value can fluctuate quite a bit between the time that a contract is launched and its expiration, which creates a lot of opportunities for day traders.
A warrant is similar to an option, but it’s issued by the company rather than sold on an organized exchange. (After they are issued, warrants trade similarly to stocks.) A warrant gives the holder the right to buy more stock in the company at an agreed-upon price in the future.
A cousin of the warrant is the convertible bond, which is debt issued by the company. The company pays interest on the bond, and the bondholder has the right to exchange it for stock, depending on where interest rates and the stock price are. Convertibles trade on the stock exchanges.
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 word margin is used differently than my discussion on Chapter 3 when discussing derivatives in part because derivatives are already leveraged. You aren’t buying the asset, just exposure to the price change, so you can get a lot of bang for your buck. (I cover the risks and rewards of leverage in detail in Chapter 5.) Margin increases your potential return as well as your potential risk, which is why they’re popular with day traders.
To buy a derivative, you put up the margin with the exchange’s clearing house. That way, the exchange knows that you have the money to make good on your side of the deal — if, say, a call option that you sell is executed or you lose money on a currency forward that you buy. Your brokerage firm arranges for the deposit.
At the end of each day, derivatives contracts are marked-to-market, meaning that they are revalued. Profits are credited to the trader’s margin account, and losses are deducted. If the margin falls below the necessary amount, the trader gets a call and has to deposit more money.
By definition, day traders close out at the end of every day, so their options aren’t marked-to-market. The contracts are someone else’s problem, and the profits or losses on the trade go straight to the margin account, ready for the next day’s trading.
In the olden days, derivative trading involved open outcry on physical exchanges. Traders on the floor received orders and executed them among themselves, shouting and using hand signals to indicate what they wanted to do. As I write this, vestiges of floor trading remain on some derivatives exchanges, but there are fewer and fewer of them.
The old-line exchanges, like the Chicago Board Options Exchange and the Chicago Mercantile Exchange, still exist, although almost all of their operations are online. As electronic trading has become more popular, it has chased many experienced floor traders into retirement because they can’t all make the transition, and it has caused much restructuring and consolidation among the exchanges.
Arbitrage literally means risk-free profit. It is possible to achieve this, sort of. Here’s how it works:
In the financial markets, the general assumption is that, at least in the short run, the market price is the right price. Only investors, those patient, long-suffering accounting nerds willing to hold investments for years, see deviations between the market price and the true worth of an investment. For everyone else, especially day traders, what you see is what you get.
Under the law of one price, the same asset has the same value everywhere. If markets allow for easy trading — and the financial markets certainly do — then any price discrepancies are short-lived because traders immediately step in to buy at the low price and sell at the high price. In the following sections I explore how market efficiency limits arbitrage opportunities and how you can step in when the moment is right.
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:
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.
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.
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.
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.
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.