Do not assume that anything you think you know or anything anyone has told you is
accurate, because it often is not with new traders. Carefully weigh each trading
opportunity listed below with an open mind before deciding. People sometimes get
into trading on the wrong instrument or method for their financial situation,
time schedule or personality and then they struggle to make it work.
The instruments of trading
There are four asset classes that are commonly traded:
- Stocks
- Options
- Bonds
- Forex
- Futures
Stocks/Shares
Trading stock shares is the most familiar and most commonly
traded of the asset classes. This does not
mean that it is easier or safer or better
than the other asset classes to learn how to trade; do not
confuse familiarity with safety or ease.
Stocks trade during the Eastern Time business day and in
some cases for a few hours before and after
the regular market hours. Part time west coast traders
can usually get a few hours of trading in
before going to work due to the time zone differences.
Stocks represent indirect ownership of a
business, including the most familiar ones in our
daily life. Do not confuse a good stock with a
good trading stock. For trading purposes you
must be emotionally indifferent to the
stock; just trade the facts of the situation. Beginning
traders often have a false sense of security
when they trade a stock that they have researched
because their stud gives them a more
comfortable feeling of familiarity. Familiarity is never
the same as less risk. If you drive a Harley
Davidson motorcycle and are in love with it then
do not trade the stock because you are too
biased.
If you have more than $25,000 to trade then this is probably a good asset for you to begin to
learn how to trade. Stock (and option) trading has the drawback of requiring an account size
of more than $25,000 to trade more than four times in five days in a margin account ("pattern
day trade rule"). To trade you need a margin account or you will need to wait three days after
closing a trade before the the funds are cleared so you can trade again. Even if you hold your
trades for longer periods of time, like weeks at a time, sooner or later you will want to make
more than four trades (entering or exiting trades) within a five day period because stocks tend
to move together 70% of the time and you may need to exit or reverse several positions in your
portfolio in the same week.
A sub-category of stock trading is penny stocks. These are "pink
sheet" stocks which are
essentially worthless empty shells. If a
stock selling for five cents goes up to fifteen
cents then you could tripled your money.
These stocks are worthless and none have ever
emerged (to my knowledge) to become a real
company. This market is ruled by pump-and-dump
schemes where someone puts out false
information via email/fax spam that some penny stock
is about to take off and become a real stock
with some new positive development at the
company. The distributor of this information
buys the stock ahead of time and then sells
into the suckers who are reacting to the
false news by purchasing the stock.
There are some account related items that you must be aware of if you trade stocks and/or options:
Pattern Day Trade Rule (FINRA rule):
A stock or options trader who executes 4 (or more) day trades in 5 business days in a margin account with an account size of less than $25,000. Some brokers, like TDAmeritrade, will enforce a more restrictive limit of 3-in-5 and will apply it to a cash (non-margin) account.
A stock or options trader who executes 4 (or more) day trades in 5 business days in a margin account with an account size of less than $25,000. Some brokers, like TDAmeritrade, will enforce a more restrictive limit of 3-in-5 and will apply it to a cash (non-margin) account.
Regulation-T (Federal Reserve rule):
Regulates margin (borrowing from your broker). Normal margin is 50% of th4e liquidation value of your account. Margin may not be applied to penny stocks (OTCBB) by your broker. Portfolio margin can give you up to six times the buying power, particularly for selling naked options. Many brokers do not offer portfolio margin and those that do will place restrictions on experience and account size (typically for accounts over $100,000).
Regulates margin (borrowing from your broker). Normal margin is 50% of th4e liquidation value of your account. Margin may not be applied to penny stocks (OTCBB) by your broker. Portfolio margin can give you up to six times the buying power, particularly for selling naked options. Many brokers do not offer portfolio margin and those that do will place restrictions on experience and account size (typically for accounts over $100,000).
Free-riding rule (SEC rule):
Cash accounts that re-use uncleared money are in violation of the free-riding rule or may have done a liquidation violation which may cause his account to be restricted for 90 days if it occurs 3 times in a year. Stocks take 3 days to clear and options take 1 day to clear. This rule might not be applied by some brokers on an option trade that is simply a rollout to a later expiration.
Cash accounts that re-use uncleared money are in violation of the free-riding rule or may have done a liquidation violation which may cause his account to be restricted for 90 days if it occurs 3 times in a year. Stocks take 3 days to clear and options take 1 day to clear. This rule might not be applied by some brokers on an option trade that is simply a rollout to a later expiration.
Options
Options are very popular and can be very profitable. I recently
made $8,000 in four days on some
S&P 500 ETF option trades using just
$12,000 of my account balance, but that doesn't happen
very often. My options had lower risk
because they were deep in the money and several months out
in expiration. It was a synthetic stock
position with a lot more leverage than a normal stock
trade would give me. This is called a stock
replacement strategy or a synthetic position
(depending on how it is done). We will
discuss this more later. Options can be the most complex
of the assets to trade. Options are based on
another asset, like stocks or futures so you need to
understand both the option and it's underlying asset. Its best to
learn how to trade options after
you learn how to trade the underlying asset
first. Options are also subject to the $25,000 requirement
of the pattern day trade rule.
Bonds
This is an area best left to specialty brokerages. Any one
corporate bond issue is thinly traded and
not suitable for independent traders working
from home. These bonds should not be confused with US
Treasury bond futures, which are futures
contracts -not the bonds themselves (see below). For long
term investors it is better to buy bonds
than to buy bond funds. As long as you own a real bond (not
a fund), you will get all your money back
with interest (unless they go bankrupt). You may
permanently lose money in a bond fund no matter how long you
invest in it.
Forex
Forex trading is the trading of the exchange rate of currency pairs, like the Euro vs. Dollar.
This seems easy to understand and is not subject to the pattern day trade rule so you can open
an account with $100 and start trading tomorrow. However, currency exchange rates change rapidly
and these pairs can cause your trade to swing wildly in value, which I find difficult to trade
successfully. In my unscientific sampling of traders I have found fewer people being successful
with forex than stocks, options, or futures trading. If your trading budget is tight then you
may need to go this route, in which case you need to follow the lead of someone who is successful,
like Todd Gordon of Aspen Trading.
Futures
I've saved the best for last. Futures trading is usually the last asset to be considered
by novice traders. I've known people who have traded stocks for more than ten years and
have never seriously considered futures trading. A big part of the reason is that it is
unfamiliar and mysterious to most people. I did not make my first futures trade until
five years after I had started trading stocks and then found that it was a lot easier
than I thought. Like any type of trading, you need to know what you are doing. Futures
trade 24 hours per day from Sunday night to Friday afternoon and are not subject to the
pattern day trade rule.
Tom Grisafi (pictured at right) makes his living trading agricultural futures, primarily
in grains, in his house in Indiana.
Futures are a contract for future delivery. For example, if you own a German car dealership you
can buy a futures contract that will lock in the price of the Euro vs. Dollar for next quarter's
car purchases to protect yourself from an adverse change in the exchange rate. The leverage in
futures contracts is very high so a little money goes a long way. Over use of leverage can lead
to excessive losses (remember the 41-43% of your trades will be losers). Futures contracts can
be had for stocks, stock indexes, commodities (corn, wheat, soybeans, etc.), US Treasury bonds,
and much more. Futures offer a wide range of uncorrelated instruments to trade but caution should
be exercised when holding contracts overnight as their value can change dramatically while you
sleep. Futures contracts are rarely traded outside the United States but foreign investors who
have US trading accounts will kick up the action around 4am Eastern Time. Novice traders often
gravitate to the S&P 500 futures electronic contract (ES), which is not the best choice most
of the time due to the relatively high tick value and narrow daily range (more on this later).
My favorite futures contracts are NQ, YM, EMD, and RUT. I know some traders who swear by the
FDAX (German stock index) but I would have to wake up too early to trade that one.
