related string. Or check the websites mentioned earlier that have collected dozens of futures websites thatprovide trading information.The better electronic brokerages should allow the futures trader to create and transmit orders directly to the floors of the major exchanges, or to after-hours processing centers. Order confirmationsand fills as well as cancellations are automatically routed to your PCvia the Internet in a timely manner. Be aware that some brokeragesroute the trader’s electronic order to a phone clerk, who then processes the order in a conventional way. This should not usually be aworry, however, as this process still occurs quickly.Learn what fees are standard and which supplementary ser-
MD6988.195-212
9/28/01
10:56 AM
Page 210
CHAPTER 8
210
vices are fee-based with the broker you choose. Online trading commissions per round-turn futures trade range from $15 to the low$30s, not including NFA fees, exchange fees, and wire transfer fees.Transferring funds electronically should not be a big concern.Reputable brokerage firms have safeguards in place for your protection during this process and for your account overall. However,it doesn’t hurt to ask up front how security issues are handled.LOOKING AHEAD FOR FUTURES TRADING
Where do the futures markets go from here? The likely developmentof online trading will look something like this:
One Screen All MarketsThe futures market represents only a part of the investment picture.Rapid innovations in the field of online trading are likely to creategreater efficiency in the trading of diverse markets. At this momentthe most active use of online trading in the futures market is thetrading of stock index futures, particularly the “e-markets,” e.g., thee-mini S&P, the e-mini Nasdaq, and the Dax on the Eurex.There is a rapidly increasing demand for the use of electronictrading of stock index futures with the electronic stock markets. Itis quite likely that by the time this book is published, at least a fewfirms will be offering both stock market trading and futures tradingon the same screen. This is the first step. There will be a natural evolution of a trading screen that allows the investor to trade stocks,bonds, futures, currencies, funds, and even derivatives of these markets on a single screen. To accomplish this, a number of fundamental changes will need to occur in the very infrastructure of the investment community.
Regulatory Compliance of the FutureThe Internet has torn down national borders. An individual sittingat a computer screen in Germany can easily access Internet websitesin the United States, Asia, and virtually anywhere else in the world.This vast access to information whets the appetite for the potentialof trading any number of foreign markets. The demand for such
MD6988.195-212
9/28/01
10:56 AM
Page 211
Developing Your Own Trading System
211
trading will inspire investment firms to make their products available worldwide. Yet a potential problem develops when the regulation of one sovereign state prohibits its citizens from accessinganother market, such as the prohibition by the CFTC for U.S. investors to trade London options during the late seventies and earlyeighties.The difference in safeguards and compliance procedures between exchanges and nations can lead to an unlevel playing fieldbetween marketplaces. Clearly, the regulatory bodies of the worldwill be required to unify their efforts, thereby creating a uniform application of regulations. Otherwise, investors will be rapidly drawnto the markets with greater flexibility. The freedom of the Internetinspires a free world market.
Back-Office Procedures of the FutureThe back office of investment firms provides the function of accounting for and balancing of investor transactions. The back-officesoftware of years past simply will not work in the electronic environment. A couple of obvious examples are the T3 settlement procedures of the U.S. stock market and the once-a-day posting of futures trades. T3 settlement means that the actual settlement ofstock trades occurs 3 days after the trading date. These 3 days in thepast were used to provide for the physical handling of the stock certificates. When electronic trading allows a trader to be in and out ofa stock several times in the same day, T3 is not only meaninglessbut also cumbersome.Single-day posting is actually a dangerous procedure when applied to electronic markets, particularly if the market is traded 24hours a day. Single-day posting actually threatens the integrity ofthe market by failing to provide a real-time accounting of investorpositions. Back offices are being forced to account for all investortransactions on a real-time mark-to-the-market basis.
Single- and Multiple-Currency AccountingAn investor in Japan may have positions in the U.S. stock marketand the German gutures markets. The online trading system of thefuture will need to provide accounting to this Japanese investor in
MD6988.195-212
9/28/01
10:56 AM
Page 212
CHAPTER 8
212
the currency of the investor’s choice. In the absence of a single worldcurrency, investors will want the option to choose what currency orcurrencies their investment is marked to and indeed have the flexibility to change the currency of record at their option.Real-time portfolio analysis will be the hallmark of the futureon time investing. In response to the capability to trade all marketsworldwide on one screen in the currency of the investor’s choice,new applications of portfolio analysis will be developed. Investorswill be able to view a real-time portfolio risk analysis and even makefine adjustments in the application of modern portfolio theory.In short, electronic trading of the future will give investorsgreater control over their investments, greater transparency in themarketplace, and near infinite diversity.
A System Must Be a SystemThe three components of a trading system described above mustcomplement one another—they must work toward a single goal.Your analysis, for example, cannot violate good money management principles. The data input must suit the analysis component.In addition, you must be able to flex your system into the world ofe-trading.
MD6988.213-226
9/28/01
10:57 AM
Page 213
C H A P T E R
9
Using AdvancedTrading Strategies
Key Concepts◆ The Function of the Arbitrageur◆ Trading Futures and Options as a Team◆ Hedging on the Futures Market◆ Learning the Value of Trading Night Markets◆ Mastering the Fine Art of Day Trading
F
rom time to time, special opportunities arise in the markets. Youneed special trading strategies to take advantage of them. As anadded benefit, you may even be able to shelter yourself from someof the risks associated with futures trading by using one of thesestrategies, but there are always some financial risks associated withtrading futures.
THE ARBITRAGE STRATEGY
Arbitrage is the simultaneous purchase of cash commodities or futures in one market against the sale of cash commodities or futuresin the same or a different market to profit from a difference in price.There is a similarity between arbitrage and spreading. The key wordis against. You purchase one position against another. These positions offset each other. Therefore, the risk, compared with the risk
Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
213
MD6988.213-226
9/28/01
10:57 AM
Page 214
214
CHAPTER 9
of holding either position outright, is less. If one side, or “leg,” goesup, the other side normally compensates by declining.Profits are made from the changes that occur between the twopositions. Your risk is not that one of the legs substantially movesagainst you. It is that no movement at all occurs. When this happens,the trade generally produces little or no profit—yet you are obligated to pay the transaction costs. Since you trade both sides of themarket, the commissions and other fees can be twice that for a regular (one-sided) trade. On the other hand, margins can be less, thereby providing greater leverage.USING OPTIONS TO “ARB”
The trader who uses arbitrage is called an arbitrageur. The objectiveof this type of options trade is to find options trading outside fairmarket values. If an option is overpriced, naturally you sell it. Conversely if an option is underpriced, you buy it. But to be an arbitrageur, you do more. If you buy, you sell a similar position to offset the risk. And if you sell, you buy at the same time.An arbitrageur spots a corn call that is substantially underpriced and buys it. This is essentially a bullish move, but to avoidthe risk of holding a net long position the arbitrageur would take ashort position to balance the risk. The profit becomes the amount atwhich the corn call is mispriced. In time, the call moves from an underpriced position to fair market value. That move is where the arbitrageur makes money. The opposite works as well. An arbitrageurmay short an overpriced call, taking a bearish stance, but at the sametime offsets the risk of a bull move by entering an offsetting positionon the other side of the market.MARKET PURPOSE
Arbitrageurs serve as price policemen. They make sure that anyprice that gets out of line gets back in line. Arbitrageurs do this byconstantly searching for commodities that are overvalued or undervalued. Then they pounce! Their market activity bids up theprices that are too low and pushes down those that have become toohigh. Since these arbitrage transactions are for most practical purposes without serious risk, the return is usually low. Little pain, lit-
MD6988.213-226
9/28/01
10:57 AM
Page 215
Using Advanced Trading Strategies
215
tle gain. But arbitrageurs accept the low return because they havelittle at risk.Theoretically, anyone who has access to the markets can makethese types of trades. But this is true only in theory. There are twoproblems. The first is the transaction costs. The return must exceedthe cost of the two commissions and the other fees associated withthe positions. Often the profit margin cannot withstand normaltransaction costs. Usually, the only ones that can make money in thisgame are trading companies or floor traders. They may have theirown seats on the exchanges and may trade in such large volume thattheir per-transaction costs are low enough to make a profit on thesetrades. For example, precious metals dealers may arbitrage goldand silver; security dealers actively arbitrage the Treasury bond futures or option markets.The second problem is the ability to spot accurately those contracts that are overpriced or underpriced. To do this, you must havea reliable pricing model and be in position to act extremely fast. Aswith the problem involving transaction costs, the professional trader within a specific commodity complex has an edge. The importantpoint for you to understand is how arbitrage works to keep commodity prices at or near their fair market value. Without arbitrageurs, you could be subjected to unexplained price moves withinthe various market complexes.FUTURES AND OPTIONS TOGETHER
Another strategy to consider is to trade futures against profitableoptions positions. Imagine that the silver markets (spot, futures, options) have bottomed. It looks as if silver will begin to stair-stephigher over the next few months. Experience says that it won’t moveup on a flat 45-degree angle. It will likely advance, retrace, advance,retrace, and so on, as do most developing bull markets.What are the alternatives? Go alternately long and short the futures markets trying to catch the moves? Or try the same thing withputs and calls? You could take a long position in either futures oroptions and hold it for as long as you dare or until it becomes profitable enough. You could also trade futures against options. Oneway to do this is to buy a call in-the-money or near-the-money. Asthe market moves higher, the call increases in value. When the up-
MD6988.213-226
216
9/28/01
10:57 AM
Page 216
CHAPTER 9
ward price trend hits an area of resistance and gives a signal that itmay retrace, you take a short position in the futures.The key to successfully using this strategy is being ready totake one of three actions:1. You must offset your short at breakeven or near breakevenif the retracement doesn’t materialize. You might want toconsider a tight stop, depending on the volatility factor atthe time of the trade. This action produces a profit on theshort futures trade, and you still have the call option intact. If silver prices continue to increase after the retracement, the option becomes more profitable. If they don’t,you don’t have your futures profit to offset the cost of theoption premium.2. You must be poised to offset your short when your retracement objective has been reached, 50 percent, for example,in profits on the futures position. You continue to hold thecall option. You either break even or lose a small amounton the futures side of the trade, perhaps the cost of the futures commission and a few cents per contract on the silver. You still have your profit in the call option.3. You must be prepared to exercise your call option if themarket violently moves limit up against your short position. It either breaks even or loses a small amount on thefutures side of the trade, perhaps the cost of the futurescommission and a few cents per contract on the silver. Youstill have your profit in the call option. The last actionforces you to exercise your call option to offset the shortfutures position. This puts you out of the market. However, the price at which you bought the call was a lower pricethan the price at which you went short. The difference isyour profit. This may or may not offset the commissionsand fees paid to take these positions, depending on howmuch of a bull move occurred before you went short.This strategy is actually creating a spread position. The approach is to use a call for the long side and a futures contract for theshort. The spread, by its very nature, helps manage the risk; it putsyou on both sides of the market at the same time. If the market runsaway in either direction, the unprofitable leg is lifted and the profitable leg is held.
MD6988.213-226
9/28/01
10:57 AM
Page 217
Using Advanced Trading Strategies
217
You need to be concerned if the market advances to the pointwhere you think it will retrace and you put on the short, only to seethe market trade sideways for a considerable period of time. If this occurs, you could exercise your call option, offsetting the short. Thehope is that the profit already accumulated in the call position wouldbe enough to pay both commissions and fees with a little left over.PUT AND CALL TEAM TRADING
Puts and calls can work well together. A put can be used to hedgeor lock in a profit on a call, and vice versa. If an investor has a putand a call in the same market and the market drops, the put is exercised in order to protect the call’s profit. It is far more important thatthe put does not interfere with the call’s ability to further profit froma continuation of a bull move. The cost of this protection, withoutjeopardizing future profits, is still only the premium cost, commission, and fees.As a comparison, a futures long position profit can be lockedin by using a short in another contract month which moves in a oneto-one linear relationship. When using futures to hedge futures (anintracommodity spread), the premium cost of the option is saved,but no additional profits are possible, regardless of how high or lowthe future ultimately trades. This strategy, as discussed earlier, creates a neutral trading position, one in which you are holding equaland opposite positions in the same futures market.A second advantage of the option-hedging concept is the useof a call to hedge a profitable put position. Should the market rise,the call can be profitably exercised. But even more important, if thebearish move continues unabated, additional profits can be generated from the put. The cost of this hedge is simply the premium costand the transaction costs.THE SPECIAL DOUBLE
A unique idea available to options traders is the special double option,sometimes referred to as a double option. This is a combination of aput option and a call option at a fixed strike price for future delivery at any time prior to the expiration date. The premium cost of adouble is usually close to, but slightly less than, the sum of the premium costs of both a put and a call purchased separately.
MD6988.213-226
218
9/28/01
10:57 AM
Page 218
CHAPTER 9
The only stipulation of the double option is that only one sideof the double can be exercised, but both sides can be traded as manytimes as desired. All the trading techniques discussed earlier withregard to puts and calls will work equally well with either or bothsides of the double, specifically the use of an option to hedge another option, options as hedges on futures positions, and options inlieu of stop orders. The only restriction is that only one side may ultimately be declared or exercised.Naturally, all the advantages of regular puts and calls are available to the double options trader. These advantages include minimum and calculable risk exposure, tremendous leverage, unlimitedprofit potential, and freedom from margin calls. The double has oneadditional advantage that places it in a special category far andabove other strategies. The “one big extra” frees the holder from dependence on market direction predictions. The double option, being the combination of both a put and a call, can be profitable regardless of whether the market advances or declines. You may oftenfind it easier to determine a market’s volatility rather than the direction it is headed. To use this strategy, you need to be confident ofa major increase in market volatility. If not, both your put and callare likely to expire worthless.To illustrate, you notice your favorite commodity beginning totrade in a tight coil or triangle formation. The coil gets tighter andtighter. You know the commodity is poised for a breakout. But willit go up or down? You’re not really sure. All you know for sure isthat it can’t trade much longer without committing itself. This is theopportunity you’re looking for to trade a double. You position yourself on both sides of the market. When the breakout occurs, youclose out the losing side and ride the winning side to the next pointof resistance, where you decide to take your profits or not. Like anytrading strategy, it is not without risks. For example, the breakoutcould fizzle. You could end up holding two worthless options. Thekey is correctly evaluating the degree of volatility.If, instead, you had purchased a put only, you would be predicting the market was heading lower, except where the put is usedin lieu of a stop to protect a new long position or to hedge a profitable long position. The put buyer is anticipating a substantial dropin price. Simultaneously, the speculator who purchases a naked callwithout the expectation of immediately being short is anticipatinga bull move.
MD6988.213-226
9/28/01
10:57 AM
Using Advanced Trading Strategies
Page 219
219
The buyer of a double is looking for a major increase in volatility, but is not sure if the market will react bullishly or bearishly. Either way, the value of either the put or the call will increase. If themove is strong enough, it will offset all transaction costs and generate a profit.
HEDGING
The National Futures Association’s Glossary of Futures Terms defineshedging as follows: hedging is the initiation of a position in a futuresmarket that is intended as a temporary substitute for the sale or purchase of the actual commodity. The sale of the futures contracts inanticipation of the future sale of cash commodities as a protectionagainst possible price declines or the purchase of futures purchasesof cash commodities as a protection against the possibility of increasing costs. Most traders hedge between cash and futures as aform of price protection.As a trader, you need to be aware of the concept of hedging because hedgers can have a major impact on prices. Also, bona fidehedgers hold commodities with strong hands—giving you an indication of where a market may be headed. If a farmer has 100,000bushels of corn stored, the farmer is de facto long corn. The farmeractually has possession of the crop. If the farmer thinks corn pricesare going to go down, one of three things can be done:1. The corn can be sold on the open market before the pricegoes down.2. Twenty 5,000-bushel short futures positions can be takenin the corn market. In this case 100,000 bushels of corn arebeing sold on the market. This makes the farmer neutral—100,000 bushels of cash corn are owned, and 100,000bushels have been promised for delivery at a given price.3. The third alternative would be to buy 20 put options.When and if it is decided to exercise these options, thefarmer would be neutral—both long (cash) and short(futures) 100,000 bushels of corn.When facing these alternatives, the farmer must evaluate hisor her personal convictions and planning time frame. If corn pricesare going to plummet indefinitely, shouldn’t the corn just be sold?
MD6988.213-226
220
9/28/01
10:57 AM
Page 220
CHAPTER 9
Wouldn’t it be better to pass the risk of storage and spoilage to theelevator or grain merchant?If the profit margin (the difference between the cost of production and the current futures price) is acceptable, it might be best toexecute a simple hedge: Short the 20 futures positions and deliverthe corn when the contract expires.If the conviction regarding price is not ironclad and there is nostrong reason to believe corn is going down, put options should beconsidered. They give the protection needed with more flexibilityand less cost.The cost of the puts depends on how near they are to being inthe-money. The trader may choose to buy 20 “cheap” out-of-themoney options just for protection in case of a crashing bear market.The trader might buy several in-the-money put options with thehope of making some money when the price dip occurs and yet stillhave the protection of knowing they could be exercised if there is aserious price deterioration.This same strategy can be used to protect a futures positions aswell. Let’s use a silver example. You go long silver in the futuresmarket, rather than buying a call option. Basically, what you are doing is reversing your futures and options positions.As expected, silver makes a major bull move. Your futures position gains just over $1 per ounce, which brings you to an area ofvery strong resistance. You are confident that the price will go higher, but you feel you should protect your gains.What should you do? You could close out your long positionand take profits. This is the most conservative approach. When youthink the bull move is about to resume, you could reestablish yourlong position. This now becomes a risk-laden speculative trade. If themarket corrects right after you get back in, you get whipsawed andend up giving back all the profits before the next bull leg was made.A more prudent approach might be to establish a put as ahedge against your profitable futures position. If you bought a putat-the-money, you could ride it down during the correction and sellit at a profit when the bull move begins. It would protect your futures profits in case the next bull move never materialized. By exercising the option, you’d close out your futures position at the pricelevel where you had a $1-plus gain. From this, you’d subtract thecost of the premium, commissions, and fees.
MD6988.213-226
9/28/01
10:57 AM
Page 221
Using Advanced Trading Strategies
221
If your confidence level was very high that the bull move wasgoing to resume after the retracement, you could calculate exactlywhat put to buy to break even on your futures position. This putwould be out-of-the-money, and therefore the premium would belower. You could think of this as a deductible insurance policy.It is cheaper because you don’t have full coverage. However,you do have protection if you are completely wrong and have atrading accident that totals your position! In the case where silverprices retreat substantially, your out-of-the-money put gains valueas it becomes an in-the-money put.PUTS AS STOP-LOSS ORDERS
Another way of thinking about this strategy is that the put is, in actuality, a stop-loss order for your futures position, but it has moreadvantages than a simple stop-loss order. First, an option providesprotection at a guaranteed price. You’re not at the mercy of the stoploss order fill.Second, you have more flexibility in deciding when to exerciseyour option. A stop-loss order is activated when its price is hit, andusually it becomes a market order. With an option, you can studythe market longer before you pick the time you want to exercise it.You have more thinking time.Lastly, the option gives protection from whipsawing markets.If, for example, your stop order is close to the market and the market makes a brief retracement before continuing its move, your stopcould be hit. This would close out your position and your gains. Theuse of an option gives you more time to assess the situation beforeyou have to act.DO YOU WANT TO ADD THE NIGHT MARKETSTO YOUR TRADING STRATEGY?
The following anecdote offers one of the strongest reasons why anycurrency or stock index trader should give serious thought to thenight markets. In late February 1989, the Nikkei 225 (the Japaneseequivalent of our S&P futures contract) saw a tightening of thespread between U.S. and Japanese interest rates. Our rates movedhigher as did theirs, but theirs moved at a faster pace. This caused
MD6988.213-226
9/28/01
10:57 AM
Page 222
222
CHAPTER 9
their bond and stock market to tumble. The Nikkei 225 eventuallyfound support at the 33,200 level. Another example occurred in November 1989 when the Berlin Wall was breached. The deutschemark began a strong bull move that evening.The point is simply that half the world is working and tradingwhile U.S. markets are closed. In the example of the Nikkei 225, theyen gapped lower the next day. An 80– 90-point gap, up or down, isnot unusual for the yen. With the Berlin Wall news, the D-mark wentup steadily for weeks. Trends (major moves) often begin and endwhile our markets are closed.This could be very expensive for you. Let’s say you are tradinga currency and something dramatic occurs after the market closesin the United States. You don’t have to spend a sleepless night waiting to enter or exit the market in the morning. All you need to dois get in touch with your broker and adjust your position at theevening session.WHAT MARKETS ARE AVAILABLE?
Besides the Nikkei 225, which is traded on the Singapore Exchangefrom 6:00 to 9:30 p.m. and 10:30 p.m. to 1:00 a.m. (U.S. Central Standard Time), you can trade gold, silver D-marks, Swiss francs, Japanese yen, British pounds, and Australian dollars on the Forex. Thesetrade from 2:00 p.m. to 7:00 a.m. U.S. CST. Don’t forget the eveningsession on the Chicago Board of Trade. You can trade T-bonds andT-notes. The hours are 6:00 to 9:30 p.m. U.S. CST.Electronic trading platforms provided by the various exchanges now make a number of contracts available for after-hourstrade in the afternoon, evening, and overnight periods. Traders canbe involved now in foreign exchange, financial instruments, energy,and agricultural and other commodity products via electronic trading. All the major U.S. exchanges—the Chicago Board of Trade, theChicago Mercantile Exchange, the New York Mercantile Exchange(NYMEX)—have after-hours trading on many of their contracts.They also have links with other international exchanges such asthe London International Financial Futures Exchange (LIFFE), theMarche a Terme International de France (MATIF), the Eurex ofFrankfort, the Singapore Commodity Exchange, and the SingaporeInternational Monetary Exchange (SIMEX). You can trade both do-
MD6988.213-226
9/28/01
10:57 AM
Using Advanced Trading Strategies
Page 223
223
mestic and foreign contracts through these after-hours electronicplatforms.Whenever you are trading foreign markets, do not neglect totake into consideration the ever-changing relationship between thecurrencies. The tick value of the Nikkei, for example, changes dailydepending on the trading activity in the yen. This means that it isprudent to use stops. Stops are twice as important for the nightmarkets!What about fills, liquidity, and margins? These are not substantially different at night. Fills are just as fast, sometimes even alittle faster, at night. The margin for the Nikkei is often less than forthe S&P. Liquidity is not usually a problem, but that doesn’t meanit won’t be at some time. Check with your broker.DAY TRADING
One last alternative strategy to consider is day trading. This simplymeans entering and exiting a position during the same trading session. You don’t carry any positions overnight or into the next trading session. You get in and out of trades within a single tradingsession.Why have traders been cautioned to avoid this type of trading?That rationale probably goes back to the old bucket shops of the1920s and 1930s. These were the times before electronic transfer ofprice quotes (telegraph messages being the exception). In thosedays, the response time between the trader in the trading parlor andthe pits was considerable. You couldn’t get tick-by-tick quotes, norcould you telephone a trading desk on the floor. Now you can doboth.The more important question is why should you even consider it at all. The profit motive is valid. You should day-trade only ifyou think you can make money. But there are other reasons as well.In one sense, you reduce risk by not carrying positions overnight.Events can happen overnight which cause markets to move violently on the following day’s open. That’s life in the pits. Day tradersare unaffected. Another plus for day trading is that it usually requires lower margins. This makes your money work even more efficiently.When you are a bona fide day trader, you can simplify your
MD6988.213-226
224
9/28/01
10:57 AM
Page 224
CHAPTER 9
analysis. Fundamental factors are mostly meaningless. You can forget about them. All the technical approaches geared to determininglong- or intermediate-term trends are irrelevant. You only needshort-term analysis. When the markets open each day, you start outwith a clean slate. Yesterday’s problems no longer exist.The biggest benefit of day trading is the discipline it forces onyou. The entire trading cycle—research, trade selection, entry-exitpoint determination, execution—takes place in a matter of hours.More importantly, you go through this routine every day, over andover. You have to become organized. There is no time to procrastinate.Despite all these positive factors to day trading, the drawbackmay be enough to stop you. Before you call your broker, considerthe amount of commission generated. You could be trading one lotand have three or four trades in a single session. Also, you need agood source for tick-by-tick price activity. This could easily run $300or $400 per month, including exchange fees. Then there is the timeinvolved. You should be in front of your quote screen whenever youare in