ures, usually by selling Treasury bonds or bills.
When  the  government  enters  the  credit  markets,  it  competes  withother big borrowers, such as corporations, for the dollars that are avail-able. The resulting increase in demand for money tends to raise the in-terest  rate.  Rising  interest  rates  reduce  the  overall  demand  for  manygoods and services, particularly those that are ﬁnanced, such as hous-ing,  durable  goods,  and  plant  and  equipment.  Thus,  initially  deﬁcitspending tends to increase overall demand, while borrowing to ﬁnancethe deﬁcit tends eventually to decrease such demand. The net inﬂation-ary impact depends on the state of the economy and the relative effectsof these two forces.
If the economy has slack in it, additional stimulation has little or noinﬂationary impact. If the economy is already booming, further stimula-tion  can  push  up  prices  dramatically.  The  relative  effect  of  the  deﬁcitdepends  on  how  it  is  ﬁnanced.  This  always  prompts  an  economic  de-bate  on  how  best  to  impact  our  economy:  balanced  budgets  versusdeﬁcit ﬁnancing.
The  second  way  in  which  government  can  affect  the  economy  isthrough its taxing policies. By raising taxes, government can slow the rateof growth in the economy. By reducing taxes, it can provide more moneyfor economic growth. Over the years, the Congress has tended to use thistechnique to stimulate speciﬁc areas of the economy.
For  example,  the  deduction  for  mortgage  interest  payments  on  per-sonal  residences  was  designed  to  boost  the  home-building  industry  andthe many other industries it inﬂuences. The investment tax credit, whichwas repealed in 1986, was instituted to encourage businesses to expandtheir plants and buy new equipment. Other tax measures have targetedareas in similar ways.
Finally,  the  third  major  government  inﬂuence  on  inﬂation  and  theeconomy is the Federal Reserve. One of its jobs is to regulate the supplyof money in the economy. If the money supply grows too quickly, prices
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will rise faster than productivity, which fuels inﬂationary pressures. If theFederal Reserve tightens up on the money supply too much, it could throt-tle a growing economy.
Despite the fact that the Federal Reserve is a government-charteredcorporation, it is not required to work with other branches of the govern-ment  to  coordinate  action  affecting  the  economy.  However,  the  FederalReserve is required to report to Congress, and Congress can change thelaws  affecting  it.  In  addition,  the  President  appoints  its  membership.  Insome cases, actions by the Federal Reserve may be opposite those of theAdministration and Congress, causing mixed economic results.
Regardless of the current political environment a savvy investor mustbe keenly aware of the current inﬂation trend and the impact it has on theinvestor’s savings, income, and portfolio. This understanding can make amajor difference in an investor’s ﬁnancial future.
FED FUNDS FUTURES CONTRACT AND MONETARY POLICY
The federal funds rate is the interest rate banks pay when they borrowFederal  Reserve  deposits  from  other  banks,  usually  overnight.  It  isclosely watched in ﬁnancial markets because the level of the funds ratecan  be  immediately  and  purposefully  affected  by  Federal  Reserve  openmarket operations.
The Federal Open Market Committee, the main policy-making arm ofthe Federal Reserve, communicates an objective for the fed funds rate in adirective to the trading desk at the Federal Reserve Bank of New York. Ac-tions taken to change an intended level of the fed funds rate are motivatedby a desire to accomplish ultimate policy objectives, especially price sta-bility. Permanent changes in the fed funds rate level are thus the conse-quence of deliberate policy decisions.
The fed funds contract, also known as 30-day fed funds futures, callsfor  delivery  of  interest  paid  on  a  principal  amount  of  $5  million  inovernight fed funds. In practice, the total interest is not really paid, but iscash-settled daily. This means that payments are made whenever the fu-tures contract settlement price changes.
The futures settlement price is calculated as 100 minus the monthlyarithmetic average of the daily effective fed funds rate that the Federal Re-serve Bank trading desk reports for each day of the contract month. Pay-ments  are  made  through  margin  accounts  that  sellers  and  holders  havewith their brokers. At the end of the trading day, sellers’ and holders’ ac-counts are debited or credited to facilitate payments.
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Fed funds futures are a convenient tool for hedging against futureinterest-rate changes. To illustrate, consider a regional bank that consis-tently buys $100 million in fed funds. Suppose the bank’s analysts believethat economic data to be released in the upcoming week will induce theFOMC to increase the objective of the fed funds rate by 50 basis points atits next meeting.
If the contract settle price (for the meeting month) implies no changefrom the current rate, the bank may choose to lock in its current cost byselling 20 contracts (or taking a short position) and holding the position toexpiration. Conversely, suppose that a net lender of funds expects a policyaction to lower the fed funds rate. It can protect its return by purchasingfutures contracts (or taking a long position).
Participants  in  the  fed  funds  futures  market  need  not  be  banks  thatborrow in the fed funds market. Anyone who can satisfy margin require-ments may participate. Thus, traders who make their living as “Fed watch-ers” may speculate with fed funds futures. This would suggest that to theextent Fed policy is predictable, speculators would drive futures prices toembody  expectations  of  future  policy  actions.  Since  the  level  of  the  fedfunds rate is essentially determined by deliberative policy decisions, thefed funds futures rate should have predictable value for the size and tim-ing of future policy actions.
Given that the trading desk may face systematic problems that hinderits ability to achieve its objective, the consequences for the funds rate maybe predictable. Speculators who anticipate such effects may ﬁnd it prof-itable to buy or sell current contracts.
In the case of fed funds, the rate is essentially determined by a de-liberative  decision  of  the  FOMC,  the  main  policy-making  arm  of  theFederal Reserve System. Hence, the fed funds futures markets must an-ticipate actions taken by the FOMC. In short, through the fed funds fu-tures markets, one can place a bet on what future monetary policy willbe.  The  committee  then  can  get  a  clear  reading  of  what  these  marketparticipants  expect  them  to  do,  which  may  at  times  be  helpful  forFOMC members who place great weight on knowing if a policy choicewould surprise the market.
If  they  are  to  be  instructive  for  policymakers,  the  fed  funds  rateshould have some predictive content. The predictive accuracy of futuresrates  historically  improves  over  the  two-month  period  leading  up  to  thecontract’s expiration, providing some evidence that the market is efﬁcientin  incorporating  new  information  into  its  pricing.  The  largest  predictionerrors have occurred around policy turning points. Nevertheless, there isconsiderable  evidence  to  suggest  that  the  fed  funds  futures  markets  areefﬁcient processors of information concerning the future path of the fedfunds rate.
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U.S. DOLLAR’S IMPACT ON GLOBAL COMMERCE
The rate of economic growth—meaning the rate of gross national product(GNP) growth—is determined by three key rates: the interest rate, the taxrate, and exchange rates. The business cycle is inﬂuenced by those rates,which in turn are shaped by monetary, ﬁscal, and trade policy. Given theglobal economic environment that we live in, it’s important to understandworld trade basics and how the dollar actually impacts global commerce.
Assume that you buy a Japanese-made car. The dealer who importedthe car has to pay an exporter in Japan for the cost of the vehicle that’sbeen sent over. The exporter wants to be paid in yen, the Japanese cur-rency.  So  the  importer  takes  his  dollars  and  buys  yen  from  a  currencydealer or bank. The number of dollars he pays for the amount of yen hegets is determined by the exchange rate. He then sends the yen to theexporter in Japan and sells you the car he’s purchased.
The same thing happens in reverse when a Japanese consumer buysan  American-made  product.  A  U.S.  export  turns  into  a  Japanese  importjust  the  way  a  Japanese  export  becomes  a  U.S.  import.  All  things  beingequal, if imports and exports occur in the same total amount, the balanceof trade will be equal.
Simply put, if the balance of trade between two countries is equal,then  the  rate  of  exchange  between  the  currencies  of  those  two  coun-tries  will  also  be  equal.  That  may  be  hard  to  grasp,  because  many  in-vestors  think  that  currency  has  intrinsic  value.  But  currency  is  onlyworth what it will buy. Ask yourself how much value a U.S. dollar has ina land where goods are bought and sold in yen. If the Japanese have noU.S. imports, they’ll need no dollars, and the dollar will be nothing morethan a souvenir.
The same is true of the yen’s value in the reverse situation. In Hous-ton,  where  goods  are  paid  for  in  dollars,  a  yen  is  worthless  unless  it’sneeded  to  pay  for  a  Japanese  import.  And  if  you  need  it  because  you’retaking a trip to Japan, that’s also counted as an import. When Americansspend abroad, they have the same effect on the balance of trade as an im-porter. In both cases, yen must be bought, and dollars ﬂow out. But if notrade takes place, there is no need for currency exchange. When it doestake place, if the Japanese need as many dollars as Americans need yen,the dollar and the yen will be equal in value. That’s how the dollar shapesup when all things are equal. But things are never equal, and that meansyou’ve got to think about the shape the dollar’s in when you’re trying tostay ahead of economic trends.
The  problem  is  that  the  United  States  is  now  the  world’s  largestdebtor nation. If we exported more than we imported, our trade accountwould have a surplus. But because we import much more than we export,
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we now have a hefty yearly trade deﬁcit. The more we import, the moreforeign currency we have to buy to pay for it. Since we need more foreigncurrency and our trading partners need fewer dollars because they havefewer U.S. imports to pay for, demand for dollars is less than demand foryen and German marks, for example. That means a strong yen, or mark,and a weak dollar.
Trade  imbalance  normally  works  itself  out.  As  we  import  more  andmore  Japanese  goods,  the  dollar  will  weaken  against  the  yen.  That  willmake Japanese goods more expensive, which will reduce our imports ofthem.  On  the  other  side,  a  weakening  dollar  makes  our  exports  less  ex-pensive. So the Japanese should buy more of them. As they import moreand  we  import  less,  trade  will  eventually  balance.  The  difﬁculty  is  thatcountries erect barriers to trade, and these barriers act to strengthen orweaken currency, which in turn affects economic growth.
The U.S. can regulate the strength of the dollar in several ways. Onthe  ﬁscal  side  it  can  enact  protectionist  legislation  and  impose  trafﬁcand  import  quotas  on  foreign  goods.  Or  it  can  push  for  internationaltrade  agreements,  which  require  its  partners  to  export  less  and  importmore. The United States can also adjust exchange rates by using mone-tary policy. If the dollar is falling or rising sharply, the Fed, acting withforeign  central  banks,  can  buy  or  sell  dollars  in  the  currency  markets.This is known as intervention to either support or weaken the dollar, aresult  that  can  be  achieved  in  the  short  run  only.  In  the  long  run,  noamount  of  intervention  can  overcome  the  balance  of  trade  when  itcomes to determining the dollar’s exchange value. Hopefully, this discus-sion  has  given  you  a  greater  appreciation  of  the  intimate  nature  of  theU.S. dollar and world trade.
CONCLUSION
Many traders ignore the macro-type analysis for the stock market that canbe put together using various forms of economic and bond data. This bigpicture  provides  the  trader  and  investor  alike  a  very  important  startingpoint before they hone in on potential trading opportunities.
There is an abundance of economic data that has an inextricable link-age to the stock market. For instance, when bond prices drop too much,forcing yields higher, this often has a devastating impact on the stock mar-ket. In general, bond yields have more of an effect on the ﬁnancial sectorversus other sectors such as the food service stocks, for example. To thispoint  you  will  see  that  when  there  is  overall  strength  in  the  ﬁnancialstocks, bond yields will drop.
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Keep in mind that many times declining long-term interest rates fuel astock market rally and this is why when stocks are not focusing on quar-terly earnings they focus on bond yields. If bond yields reach too high alevel, companies may have to start paying more to borrow money, whichadversely impacts proﬁts. Of course, declining proﬁts in turn lead to de-clining  stock  prices.  To  overcome  rising  bond  yields,  earnings  have  tocome in better than expected to see appreciation in the stock price.
Another trend to watch closely is when investors leave stocks to gointo bonds, making it difﬁcult for companies to raise money. This also in-dicates what is known as a “ﬂight to quality” where investors decrease themoney ﬂow into stocks to pursue safer investments.
Due to its adverse impact on corporate proﬁts, inﬂation is another keyfactor that needs to be monitored. For example, the prices-paid elementof  the  Institute  of  Supply  Management  report  gauges  inﬂation.  If  prices-paid come in too strong, not only will bonds sell off, but stocks will sell offas well.
For these same reasons the Consumer Price Index, which measuresprices  on  consumer  goods  and  services,  and  the  Producer  Price  Index,which  calibrates  prices  on  various  goods  such  as  commodities,  capitalitems, automobiles, and textiles, should also be watched closely for inﬂa-tionary pressures.
Another  report  that  can  impact  the  inﬂationary  outlook  is  the  retailsales report. If this report, for example, experiences an upward revisionfrom the previous month this can cause both the stock and bond marketto  sell  off.  Basically,  these  four  inﬂation-type  reports  impact  both  thestock market and the bond market in the same way. The bottom line hereis that the primary stock market catalyst is corporate proﬁts. A major fac-tor for proﬁtability is having an economy that shows low inﬂation.
Overall, if the economic reports are coming in strong, the bond mar-ket will begin to be concerned about the Fed increasing interest rates toderail possible inﬂation. This will in turn cause bond yields to rise and fos-ter an environment where stocks are more than likely going to decline be-cause of the increased competition among the investment community onwhere to get the best return.
Another  major  reason  you  should  track  these  reports  is  that  just  likecorporate earnings, economic reports and Federal Reserve decisions alsocome with their own expectations. For example, if the stock market is an-ticipating a raise in rates by the Federal Reserve and it doesn’t happen, thenexpect the stocks to decline across the board because stocks will repricethemselves to reﬂect the higher rates. These higher rates dampen both busi-ness and consumer spending due to the fact that borrowing costs are nowhigher. The higher rates can sometimes actually spur a recession and canreduce inﬂation with interest rate–sensitive stocks being the beneﬁciary.
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Now of course, when the Federal Reserve cuts rates this can have avery positive impact on both the stock and bond market. Also, if rates areunchanged then more often than not this generates a positive signal to theequities market. In this same vein, there is always a concern that the Fedcan  reduce  interest  rates  too  much,  pumping  too  much  money  into  oureconomic system, which can fuel stock prices, resulting in asset inﬂation.Another  more  cryptic  thing  to  monitor  is  certain  chatter  that  occa-sionally  comes  out  of  the  Federal  Reserve.  For  instance,  a  news  storyabout  a  key  Federal  Reserve  ofﬁcial  warning  about  possible  inﬂation  orAlan Greenspan talking about overvalued assets could ignite a stock mar-ket sell-off.
The point I want to leave you with is that this type of macroanalysis ofthe economic environment is an essential starting point when developinga general bullish or bearish scenario. This analytical backdrop has alwaysgiven me the extra conﬁdence I needed to pull the trigger based on Elliottwave, MACD, or any other technical tool I choose to employ before mak-ing a trading decision based on a directional bias.
Additionally, paying close attention to interest rates can help you toforecast market direction. Although many delta neutral strategies are notdependent  on  market  direction,  it  never  hurts  to  be  able  to  anticipatemovement. Since prices have extremely erratic ﬂuctuation patterns, moni-toring interest rates is a relatively consistent method that can help you toﬁnd proﬁtable trading opportunities.
You  don’t  have  to  become  an  expert  in  economics  to  gauge  marketperformance; but you do need to know what you’re looking for and howto use the information that’s out there. Part of a trader’s learning curve de-pends on his or her ability to integrate an understanding of the big picturewith the multitude of details that trading individual stocks requires. Sincemoney is the lifeblood of the stock market, understanding how it movesand where it moves to is a major key to ﬁnancial success. Not only eventsmove the markets, but also the international ﬂow of money as investorsseek  the  highest  possible  rate  of  return.  The  thought  of  internationalmoney  ﬂow  may  be  overwhelming  to  many  of  us,  but  it  is  an  importantpart of the big picture. So put on your high waders, the water’s just ﬁne.
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MasteringtheMarket
In  the  previous  chapter,  we  examined  some  of  the  macroeconomic
events that can cause changes in the stock market. Rising interest rates,comments  from  the  Federal  Reserve,  and  economic  reports  can  allcause changes in the economic outlook, which can cause stock prices tomove sharply higher or lower. When one examines the economic outlookin  order  to  make  investment  decisions,  it  is  known  as  a  top-down ap-proach to investing.
Some  traders  prefer  to  take  a  bottom-up approach.  In  this  case,  youare  more  concerned  about  the  individual  investment.  For  example,  youmight start by studying an individual company and understand its detailsbefore making a decision.
In  this  chapter,  we  take  more  of  a  bottom-up  approach.  We  want  tohelp you identify the fundamentals of proﬁtable investment. You will haveto decide, probably by trial and error, which of the many analytical tech-niques and market-forecasting methods work well for you. I ﬁnd many in-vestment  tactics  to  be  irrelevant  to  proﬁt  making,  preferring  to  usestrategies that are nondirectional in nature. However, there are a few basicguidelines that will enhance your ability to increase your account size con-sistently by making good investment selections.
DESIRABLE INVESTMENT CHARACTERISTICS
Finding promising trades is perhaps the most difﬁcult issue to address whenﬁrst starting out in the investment arena. While there are no absolutes, there
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are a few guidelines that will enhance your ability to identify proﬁt-makingopportunities. A desirable investment has the following characteristics:
• Involves low risk.• Has a favorable risk proﬁle.• Offers high potential return.• Meets your time requirements.• Meets your risk tolerance level.• Can be understood by you, the trader.• Meets your investment criteria.• Meets your investment capital constraints.
Involves Low Risk
First and foremost, a good investment must have low risk. What does lowrisk really mean? The term’s signiﬁcance may vary with each person. Youmay be able to accept a risk level of $5,000 per trade based on the capitalyou  have  available.  However,  an  elderly  person  on  a  ﬁxed  income  mayﬁnd $100 to be too much to risk. Acceptable risk is based on your avail-able  investment  capital  as  well  as  your  tolerance  for  uncertainty.  Youshould  trade  only  with  money  you  can  afford  to  lose,  as  there  is  risk  ofloss in all forms of trading.
Has a Favorable Risk Proﬁle
Every time you contemplate placing a trade, you need to create a corre-sponding risk proﬁle. Whether you trade shares or commodities, investin  real  estate,  or  put  your  money  in  the  bank,  every  investment  has  acertain potential risk/reward proﬁle. Some are more favorable than oth-ers. Studying a risk proﬁle can show you the potential increasing or de-creasing proﬁt and loss of a trade relative to the underlying asset’s priceover  a  speciﬁc  period  of  time.  As  the  variables  change,  the  risk  curvechanges accordingly.
In order to ﬁnd the best investment, you have to look for trades thatoffer  optimal  risk-to-reward  ratios.  For  example,  which  of  the  followinginvestment choices has the better risk-to-reward ratio?
• Trade A: potential risk of $1,000; potential reward of $1,000.• Trade B: potential risk of $1,000; potential reward of $5,000.
Anyone would rather make $5,000 than $1,000. However, to actuallymake a good decision, you must also have enough knowledge to discernwhich  trade  has  the  greater  probability  of  working  out.  Another  key 
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ingredient is time frame—the time it takes to make the money. If trade Acan make me $1,000 in one month with a 75 percent chance of winning,and trade B takes a year to make $5,000 with a 75 percent chance of win-ning, I would rather go with trade A. In one year, I could potentially make$9,000 [(12 × 1,000) × .75] repeating trade A, and only $3,750 ($5,000 × .75)using trade B. This is referred to as an expected value calculation.
The risk/reward proﬁle of any investment must take into account the
following elements:
• Potential risk.• Potential reward.• Probability of success.• How long the investment takes to make a return.
Offers High Potential Return
Risk  comes  hand-in-hand  with  reward.  A  trader  cannot  be  expected  totake a risk unless reward is also in the equation. Believe it or not, I haveseen  countless  investors  make  foolish  investments  where  the  risk  out-weighs  the  reward  many  times  over.  Why  would  they  do  such  a  thing?Usually because they simply haven’t taken the time to verify the potentialrisk and reward of the trade or they are taking advice from someone whodoesn’t know any better.
The  best  investments  have  an  opportunity  for  high  reward  with  ac-ceptable risk. In addition, the good trades have a high probability of win-ning  on  a  consistent  basis.  I  consider  75  percent  an  acceptable  winningpercentage.  This  means  I  win  three  out  of  four  times  I  place  a  trade.  Abaseball  player  who  could  do  this  would  have  a  .750  batting  average—which is unprecedented in baseball history.
Meets Your Time Requirements
The process of locating and monitoring your investments must meet yourtime constraints if you are to be successful. In other words, if you do nothave the time to sit in front of a computer day in and day out, then yourbest investments will not be day trades (entering and exiting a position inthe  same  day).  If  you  don’t  even  have  the  time  or  inclination  to  look  atyour investments over a one-week period, then you have to take this intoconsideration.  The  time  you  have  available  for  making  investment  deci-sions  and  monitoring  those  investments  will  affect  the  types  of  invest-ments you should make. If you don’t have enough time to pay attention toa trade that needs to be closely monitored, chances are you’ll lose moneyon it. The best investments will match your time availability.
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Meets Your Risk Tolerance Level
Your risk tolerance level is directly proportional to your available investmentcapital. Risking more than you can afford to lose creates stress that impairsyour ability to make clear decisions. Some people have the ability to handleuncertainty better than others. It is important to accurately assess your ownrisk  tolerance  levels  and  stay  within  those  boundaries  as  you  progress  upyour own trading learning curve. As experience in the markets naturallydevelops your conﬁdence level, your risk tolerance level will increase.
Can Be Understood by You, the Trader
One of my most basic investment rules is as follows: If you don’t knowhow hot the ﬁre is, don’t stick your hand into it. This rule is broken on aconsistent  basis  by  many  beginning  and  intermediate  traders.  In  addi-tion, many seasoned traders singe their ﬁngers as well. Basically, if youdon’t understand the exact characteristics of a trade, it is better to walkaway from it.
It is imperative that you familiarize yourself with the trades you place.Each trade has a unique personality. Your personality and your trade’spersonality have to match for you to be successful over the long run.
Meets Your Investment Criteria
Your  personal  investment  criteria  can  come  in  many  shapes  and  sizes.Each  individual  has  personal  goals,  expectations,  and  objectives  whenmaking investments. When I ask my students what they want out of theirinvestments, the typical response is to make money. However, there are anumber of related issues that also must be evaluated, including:
1. Capital gains (stocks—medium- to high-risk securities). What are the
tax implications of your investing and trading practices?
2. Interest  income (ﬁxed  income  securities—medium-risk  bonds  andlowest-risk  U.S.  government  securities).  Is  your  objective  to  earninterest income?
3. Security (government  securities—lowest-risk  securities).  Do  youwant  to  invest  in  only  low-interest,  low-return  investments  such  asU.S. government securities (e.g., Treasury bonds)?
Meets Your Investment Capital Constraints
Do  the  investment  requirements  match  your  capital  available  for  invest-ment?  Just  as  your  investment  strategy  must  meet  your  personality  and
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time constraints, the capital you have available will have a major impacton what you invest in, how often you invest, and the number of contractsyou  can  afford  to  trade.  For  example,  if  you  have  a  small  account  (lessthan $10,000), you will invest very differently from someone with $1 mil-lion. In addition, if you’re trading commod