Introduction to FOREX Trading
When people think about investing in the financial markets they typically think about stocks, bonds, mutual funds, and exchange-traded funds. Rarely do investors think about so-called alternative investments? There is, in fact, a financial market that dwarfs the world stock markets called Forex (an abbreviation of Foreign Exchange). Forex is a global decentralized market that determines the relative value of one currency over another at any given moment.
The Forex Spot Market
In the early days, foreign currency trading was almost entirely restricted to the largest financial institutions to facilitate international trade, called the Interbank Market. Over time an over-the-counter (OTC) market evolved among pioneering speculators using phones and fax machines to buy and sell currencies. In the spot market, trades are settled immediately; however, even though the trades were considered executed, the physical delivery of the currencies can take up to two days after the trade was executed.
In the days of phones and fax machines, this was called T+2 - trade plus two days. Where the Interbank Market was primarily facilitating international trade, including taking long-term positions to hedge against the devaluation of currencies, the speculator was attempting to make a profit on the fluctuation of price in currencies.
The rise of the Internet and the electronic trading of stocks online created an enormous retail trading market. This new retail market attracted a network of online Forex brokers offering direct currency trading services to speculators.
These brokers and a number of software developers began to develop electronic trading platforms to trade online in the late 1990s. The influx of retail investors into a decentralized, over-the-counter, secondary market, with no central laws, regulations, or governing body, trading across sovereignties, attracted massive financial fraud.
In addition to prevalent confidence schemes, in the early days, it was commonplace for investors to be at odds with brokers manually filling their buy and sell orders and trading against them. Investors eventually organized against unscrupulous brokers and shared tips and techniques about timing trades and hiding their orders from the brokers’ clearing desks.
Today, execution is electronic with no human intervention or manipulation, making the markets faster, safer, and more efficient. The growth and success of Forex over the years has opened doors to an ever-increasing number of online trading platforms, including the automation of trading via software programs or algorithms directly accessing brokers through APIs (Application Programming Interface). The development of these automated trading systems is where BlackBox Alpha has found its niche.
The Benefits of Forex
Forex is the largest and the most liquid of the financial markets.
The volatility of the Forex market enables traders to profit on exchange rate fluctuations.
Forex traders profit regardless of market direction, whether the U.S. dollar is rising or falling.
The trading cost of the Forex market is very low, creating one of the most cost-effective means of investment trading.
Forex accounts are traded on margin, allowing investors to leverage their capital to trade larger positions and provide the potential for greater returns.
The Forex market operates 24 hours a day, 5 days a week.
The Mechanics of Trading Currencies
The Forex market is traded in pairs. Similar to traveling in Europe or Japan and going to a bank to exchange U.S. dollars, you receive a quote from the bank to convert your dollars. You sell your dollars to the bank to buy Euros or Yen. In the foreign currency market currencies are quoted in pairs, for example, the amount of U.S. dollars you need to buy a Euro.
In this way, the value of a currency is determined by its relationship to another currency. In this example, the U.S. Dollar and Euro are listed as EURUSD. The Euro is considered the base currency, and the U.S. Dollar is considered the quote currency. The currency pairs show how much of the quote currency is needed to purchase one of the base currency.
Unlike the stock markets, most Forex brokers do not charge a commission. The brokers’ fees are typically built into the spread - the difference between the bid price and the asking price. The term pip is the common term used to designate price differences between any two currencies (derived from “Performance Index Paper”, which large corporations use to hedge their currency risk). A pip is usually the fourth decimal place in a price quote. (The exchange rate for the Japanese Yen is an exception; the pip is represented by the second decimal place).
In the example above, the pip is only 1/100th of one penny in price movement. This may seem nominal, but the liquidity in the foreign currency market is enormous and just a slight one pip move represents a massive amount of money. The combined average daily trading volume of the NASDAQ and the New York
Stock Exchange this year is estimated around $188 billion. The average daily trading volume of Forex is estimated at $5.3 trillion. The foreign currency market is almost thirty-times bigger than the major U.S. stock markets!
In addition, most Forex investors trade on margin using leverage. Leverage is a financial tool that allows you to multiply the value of your investment x times. When you open an account with your broker, you can choose your leverage. In the United States, the National Futures Association (like the SEC, the NFA is the regulating body for the U.S. futures industry, including foreign currency trading) limits leverage in foreign currency trading to 50:1, but some foreign brokers allow leverage up to 500:1, or even 1000:1.
The value of each pip in price movement depends on four factors: the currency pair being traded, the size of the trade, the account leverage, and the exchange rate. The calculations can get somewhat complicated, but to put it in simple terms, if the size of your trade is $1,000 and your leverage is 50:1, your investment will be $50,000.
Using the price above, a single pip move is equivalent to $5.00. In other words, a 0.0074% price movement would be equivalent to a 0.5% move in equity. You can begin to see the power of Forex trading. Many times positions are only open a few hours, or even a few minutes or seconds using algorithms for high-frequency trading (HFT). As trades close, and equity increases, subsequent trades can begin compounding on the new equity levels.
Another peculiarity of Forex is its continuous operation. Because the foreign currency market is global, it is open 24 hours per day from Sunday, 5:00 pm EST/EDT when the market opens in Sydney (Australia’s Monday morning) through Friday, 5:00 pm EST/EDT when the market closes in New York. In a full year, the U.S. stock markets are typically open 2,125 hours, while the Forex market is open 6,330 hours.
This is equally intriguing as it is disconcerting to new foreign currency traders. News events from central banks across the globe can have a significant impact on the prevailing trend of a currency pair. For example, a trader may go to sleep with an EURUSD trade open overnight and wake up to find the market has moved against him or her when the Bank of Japan made an interest rate decision or the Reserve Bank of Australia’s governor gives a speech.
Basic Trading Strategies
In foreign currency trading, as in all trading, there are two majority philosophies of trading. The first is fundamental trading, which considers a country’s overall economic health in relation to other global economies, and how the different currency pairs will respond. The second is technical analysis and the attempt to predict price movements based on trailing indicators and momentum indicators.
Fundamental Forex traders evaluate currencies and their countries, like an equities investor would evaluate companies, and use economic announcements to gain an idea of the currency’s true value.
Fundamental trading may take a long-term perspective on currency trends, including banks, multinational corporations, and countries holding large positions in foreign currencies as a hedge against future price movements. Another long-term fundamental strategy includes the carry trade, which is selling a currency that is offering lower interest rates and purchasing a currency that offers a higher interest rate - in other words, borrow low, lend high.
The trader using the carry trade strategy captures the difference between the pairs’ interest rates. Trading a leveraged account, a foreign currency investor can make the trade highly profitable even with only a small difference between the two rates.
An example of a USDJPY (U.S. dollar, Japanese Yen) carries trade happened in the late 90s when Japan decreased its interest rates to zero. Investors borrowed yen and bought U.S. dollars. The investor would earn the difference between the Japanese interest rate and the U.S. interest rate. With leverage, the returns could be substantial.
For example, an account trading at 50:1 leverage could create a substantial return on a 3% yield. With a $10,000 trade, a trader would control $500,000. In the currency carry trade from the example above, the trader would earn 3% per year. At the end of the year, the $500,000 investment would equal $515,000, or a $15,000 gain.
Because the original investment was only $10,000, the real return would be 150%. It is these types of examples that are so alluring, and attract traders to the Forex market. However, the truth is that this strategy only works if the currency value remains unchanged or appreciates. With a highly leveraged account, the risk exposure over a year is enormous.
If (or when) the currency value depreciates, or briefly swings, the exposure could cause a margin call if the trader’s account is not properly funded. The truth is the trader would have to maintain a substantial amount of cash in his/her account to cover the margin requirements, which would substantially reduce the effective return.
For the spot market investor trading a leveraged account, a long-term position increases market exposure and risk. For the purposes of our discussion, fundamental investing is typically trading the news, which is often a very short-term strategy. Trading the news is an attempt to anticipate a country’s economic reports and their impact on the exchange rate of currency pairs.
These trades are typically open for only a few minutes, and very often the exchange rates swing wildly leading up to and following the announcements. Scheduled news events include major economic reports, such as interest rate decisions, gross domestic product, unemployment claims, consumer confidence, etc. Because these events are scheduled to the split second, trading can become very volatile as the market tries to anticipate the outcome before the announcement, digest the announcement, and finally respond to it.
In the chart above you can see the effects of a speech given by Federal Reserve Chairman Ben Bernanke. Prior to the speech, you begin to see the price vary wildly, more than 25 pips during a single 15 minute time period, and then suddenly drop more than 85 pips as the market reacted to the speech. Traders trading the news attempt to predict breakouts like this and place trades to capitalize on the sudden price movement. (Note: the price eventually dropped close to 140 pips, and then reversed to eventually return to the pre-speech highs just 48 hours later).
Because reactions to news events are notoriously difficult to predict and measure, many foreign currency traders gravitate to technical investing.
The basic presumption of technical investing is that historical price action predicts future price action. The challenge of technical analysis is developing a strategy using the enormous amount of market data available to create a statistically significant forecast model.
Let’s take a closer look at the assumptions a technical trader makes:
1. Historical price action predicts future price action. In other words, by studying historical price movements a trader may recognize a consistent pattern that sets up the change in price.
2. Anything that influences an exchange has already been factored into the price by the market. This includes economic, political, social, and psychological factors. The idea is that with millions of investors and trillions of dollars exchanging hands each day, the trend and flow of money are what becomes important.
3. History repeats itself, often, in predictable patterns. These patterns are called signals. The analyst's goal is to recognize a current market signal by examining past signals.
4. Prices move in trends. Once a trend has been established, it usually continues for a period. (Sound familiar? An object in motion tends to stay in motion unless acted upon by an external force. A news event, for example.)
Traders use price charts, volume charts, and mathematical representations of market data as pieces of their strategies to find the ideal entry and exit points for a trade. Some of the more popular or recognizable representations, or studies, include Moving Averages, Bollinger Bands, Relative Strength Index (RSI), Stochastic Oscillator, and Fibonacci Retracements. There are literally hundreds of blogs, tutorials, and courses available on each of these studies. Let’s take a closer look at one of the easier to understand indicators.
Moving averages are one of the most commonly used indicators. The benefit provided by a moving average is to reduce exchange rate fluctuations. The moving average smoothes out these fluctuations in price, making it easier for the trader to identify and authenticate market trends from the normal up-and-down movements in price common to all currency pairs. Technical traders seek to find a trend when studying pricing data. If a trader identifies an uptrend, the probability is that if they place a buy order their position will increase in value.
Technical traders also attempt to identify trend reversals using moving averages. Trend reversals happen at the point the market determines a currency has reached its peak value. By identifying a trend reversal, the trader can close their positions at the most profitable level. Moving averages can help in both regards.
In the EURUSD chart above you can see the smooth moving average line. The price movement begins to flatten out as the moving average line moves down at a sharp angle. The point the price movement crosses above the moving average line indicates a trend reversal. This is confirmed by the sharp price move down, which immediately recovers above the moving average line.
Also, note that the price movement on the right side of the chart continues to move above the moving average line. When the price touches the line, it bounces back up. This is also a strong indicator of a trend.
You can see how the moving average indicates a trend, and how a price reversal signals either a buy or close, or both. You can also see how a Forex trader makes money regardless of the direction of the market:
If a trader had a sell order open (i.e. the trader would be selling Euros, and buying U.S. dollars) that was gaining value as the trend moved down (as the USD gained value), the trader would begin taking note when the price flattened and began moving in a range between 1.3420 - 1.3440. This would indicate a good time to close their trade and lock in their profit.
The trend reversal illustrated above also indicates a good entry point to place a buy order and begin riding the trend back up.
The example above is not an unusual scenario in foreign currency trading but is idealistic. The responsibility of every trader is to preserve their investment capital. The challenge of every trader is to manage risk. For every pattern identified, there will be an exception.
For example, in the chart above, the price flattening could have just been a slowdown in the trend, perhaps due to reduced volume as the Sydney market closed and the London market opened. A trader may have placed a buy order when the price moved above the moving average, only to find the trend continue to move down (against the trader’s open buy position) when the market spiked down again around midnight.
It is very important for any investors considering foreign currency trading to understand what the risks are. The Commodity Futures Trading Commission (CFTC) is required to disclose the numbers of unprofitable traders, which hovers between 72% and 79% every quarter, according to its filings. Between 72% and 79% of traders lose money every quarter.
In addition to a very fast moving market and fundamental differences between the stock market and Forex market, fraud is a significant risk to any new foreign currency investor. In fact, CFTC Chairman Gary Gensler recently said Forex scams were the “largest area of retail fraud” his agency oversees. The National Futures Association (NFA), an agency established by Congress that is funded by Forex brokers, issued an investor alert in February 2007, which included:
“Unfortunately, the amount of forex fraud has also increased dramatically. Since 2001, the Commodity Futures Trading Commission (CFTC) has filed 93 enforcement actions in federal court against hundreds of firms, owners and employees for defrauding over 25,000 customers who lost over $395 million in forex schemes.” (Investors can review the full Forex investor alert here:
Tips for New Forex Investors:
1. Only deal with reputable brokers. Only trade with a broker that is a member in good standing with a recognized regulator. The regulators in the United States are the Commodity Futures Trading Commission (CFTC), and the National Futures Association (NFA). The agencies keep a public record of all complaints against regulated brokers and their resolutions online.
2. After you have identified a reputable broker, open a Forex demo account. Practice trading on this account for at least six months to a year before opening a live trading account. Learn to identify trends in the market. Observe how news reports affect the various currency rates. Learn to manage risk.
3. Become a student of the markets. Study foreign currency trading by reading blogs and articles on technical analysis, join the active trading communities online, and most importantly, actively trade your demo account to put the theory to practice.
4. Only invest risk capital - money you can afford to lose. It is extremely important for investors to understand that foreign currency trading should only be a minor piece of their portfolio. Even with our experience and expertise, foreign currencies are only a minor part of BlackBox Alpha’s portfolio.
A Word on Leverage
When trading on margin, a trader is borrowing money from their broker. The collateral for the money borrowed is the funds in the trader’s account. The collateral is expressed as the minimum margin the trader is required to hold in their account.
As we mentioned early in this blog, a 50:1 leverage lends the trader $50 for every $1 the trader invests. In other words, if a trader makes a $1,000 investment at 50:1 leverage, the trader has the potential to earn profits on a $50,000 trade. Of course, in addition to the earning potential, this leverage gives the trader, the trader faces the risk of losing money based on the $50,000 trade, and these losses can add up quickly. Traders suffering a loss without sufficient margin remaining in their account run the risk of triggering a margin call.
When a trader has open trades, the broker continually calculates the unrealized value of the trader’s positions to determine their Net Asset Value (NAV) - the value of all positions if they were closed at the current market rate. If the open positions lose so much potential value that the remaining funds in the account are in danger of falling below the minimum margin limits, the trader could receive a margin call.
Depending on the trader’s broker, he/she could receive a request to add more funds in his or her account, or the broker may simply close all open positions at the current market price to limit further losses. In either case, the trader could end up losing the entire balance of his/her account and may even owe additional funds to cover his or her losses.
When selecting your broker, make sure you understand what the broker’s margin requirements and policies are.
The most important concept for any trader to learn and understand is risk management. Risk should be a calculation based on statistics and probabilities. Risk should never be a gamble. The difference between gambling and speculation is risk management.
The most basic risk management includes leverage, position size, and stop loss. By considering each of these, a trader can calculate the potential losses and adjust accordingly to bring the potential losses in line with what the trader is willing to risk with each trade. In the example we used in The Mechanics of Trading Currencies section of this blog, using a 50:1 leverage, and investing $1,000 in a trade (the position size), a single pip loss in the EURUSD would result in a 0.5% loss in the value of the trader’s position.
If the trader’s total account value was $100,000, this would be equivalent to a 0.005% loss in value. Using these calculations, the trader can set the positions to stop loss to an acceptable level. For example, a 100 pip stop loss would limit the loss of this trade to 0.5% of the trader’s total account value.
The next steps in risk management would include observing the market to identify trend reversals and reduce the risk of a stop loss, observing the strategies profitability to adjust risk accordingly and test how changes in various settings affect the overall profitability and risk: reward ratios.
What is Quant Trading?
Quantitative trading is the method of creating trading strategies based on an analysis which relies on mathematical computations to identify trading opportunities. Price, volume, and momentum are some common data inputs used in quantitative analysis. The the benefit of algorithmic trading in the foreign currency market is eliminating trader psychology, the speed of execution, and the ability to trade 24 hours a day.
The Process of Developing an Algorithm
The process of developing an algorithm is extremely rigorous and takes several months to create, and sometimes years to optimize. The general steps in developing an algorithm are:
1. Identifying a pattern in the markets.
2. Quantifying the pattern with mathematical formulas (this becomes the beginning of the trading model).
3. Observing the markets to see if the model holds up, and to identify and quantify any instances of false positives.
4. Programming the trading model.
5. Backtesting the trading model against several years of market data. Identifying patterns that affect risk: reward ratios, return to Step 4...
6. Forward testing the model in live market conditions. Again, identifying patterns that affect risk: reward ratios, return to Step 4...
The cycle of programming, backtesting, forward testing, and programming again may continue hundreds of times. In addition, walk forward testing is the process of continually testing proven algorithms against current market conditions. For example, a proven algorithm may be continually running a dozen or more tests on different variables that may affect risk: reward to identify more optimal settings for current market conditions.
Before beginning our analysis, it is worthwhile noting that this blog ultimately aims to help a particular type of individual: investors. These individuals, who have the capital to invest deriving from various sources (savings, inheritance, proceeds from the sale of real estate, etc.), are those most concerned by what follows.
They want to invest this sum of money so it yields a profit, thereby increasing their capital over time. So investors look first and foremost for a return, which may take the form of regular income, capital gains, or both at once.
At this stage, it should be noted that the expected return for the given time horizon must be positive in order to achieve the desired growth. It must also be higher than average inflation so that investors can preserve their purchasing power over time, and therefore their real wealth. Furthermore, net return—that is return after tax—should ideally be taken into account.
So, along with the risk of capital loss, inflation is one of the two greatest risks for investors, as it can seriously affect their capital over time. As such, it is worth defining more precisely.
Inflation can be defined as an increase in general price level, with the chief consequence of a decrease in consumer purchasing power. Conversely, deflation is defined as a decrease in the general price level. Salaries, retirement pensions, and other social security benefits are generally indexed to inflation, thus enabling consumers to maintain their purchasing power over time.
The objective generally fixed by central banks for inflation is around 2%. However, in absolute terms, this figure should be revised upwards from an investor's point of view, considering the product categories most relevant to consumers in the price index. Indeed, when focusing on price increases for food, housing, energy or health-related spending, the average rate of inflation appears to be much higher.
In general, a market basket is used to calculate price changes. This basket includes a representative selection of goods and services consumed by private households. It is subdivided into various categories of expenditure, and each main category is weighted according to the share it represents in household expenditure.
A stock is an equity security that makes its holder one of the owners of the company that issued it. “Shareholders therefore benefit from social rights (right to vote at shareholders meetings, right to elect and be elected to the Board of Directors) and economic rights (right to dividends, right to receive a share of the proceeds of liquidation if the company goes bankrupt and a preferential right to buy new shares in case of capital increase).”
Investors who buy stocks have the right if the company is doing well, to a share in the profits generated, paid in the form of dividends, which are the returns generated by the investment. In addition, if the value of the company increases, which is reflected in a rise in its share price, investors can also make a capital gain on their initial investment.
a) Types of Stock
So-called common stocks are those which give their holder all the rights mentioned above. Dividend-right certificates, however, only confer the economic rights. This type of stock is limited in practice and the most common example is the dividend-right certificates of the pharmaceutical company Roche.
Firstly, we can distinguish value stocks or income stocks, which pay regular, high dividends. Investors looking for regular returns will try to identify a stock that is considered good value for their level of earnings and dividends.
Growth stocks are generally characterized by a very high market value in relation to current profits but offer the prospect of future earnings growth. They do not usually pay high dividends as they reinvest practically all their profits to ensure their growth. Price fluctuations are more significant and they are considered riskier than value stocks.
Secondly, we can distinguish small and large capitalizations, but the size and definitions vary from country to country.
Stocks are also differentiated according to their reaction to the economic climate. Companies sensitive to economic cycles, such as airlines or auto manufacturers, are called cyclical stocks. Conversely, companies less sensitive to cyclical fluctuations, such as those in the healthcare or food industries, are called defensive stocks.
Finally, preferred stocks are hybrid securities between stocks and bonds. They give preferential rights to dividends; preferred stockholders are paid before any dividend payout to common stockholders. A fixed preferential rate is promised, provided that the company can distribute dividends. If not, dividends may accumulate to the following year. These are known as cumulative preferred stocks. In case of bankruptcy, holders of these securities are below bondholders in the order of reimbursement but above common stockholders.
b) Developed and Emerging Countries
Stocks can be classified into two main categories depending on the country: those of developed countries and those of emerging markets. By emerging countries, we mean all countries that are not considered advanced according to the criteria defined by the International Monetary Fund (IMF). This list is the same as the one mentioned above.
Other than the cyclical and defensive sectors defined above, it can also be useful to distinguish between different industries in order ultimately to select individual securities (stock picking).
d) Forms of Investment
Investment in this asset class can consist of buying individual stocks directly, equity funds, market or sector index funds (tracker funds), or futures contracts. An equity fund offers the advantage of investment diversification with low capital, and management by specialists who can react quickly to market information.
However, most equity funds practice so-called “relative management”, that is in relation to a benchmark or reference index. They measure their performance in reference to the benchmark. In practice, 80% of funds underperform their benchmark and a fund that outperforms its benchmark never stays at the top of the rankings for 10 consecutive years.
Moreover, equity funds suffer from mild illiquidity as investors cannot exit the market immediately, unlike selling stocks or index funds. They must await the NAV (Net Asset Value), calculated daily at best, to find out their exit price.
Finally, equity funds generally involve a significant fee structure. We recommend instead investing directly in the benchmark, by simply buying a market or sector index fund, or using futures.
An index fund (or tracker fund) offers more flexibility by making it possible to set purchase or sale limits, or even stop losses (which is not possible with equity funds), costs investors less and provides attractive diversification in terms of exposure to a market or a particular sector. Counterparty risk must, however, be taken into account for this type of investment. Indeed, it is important to be familiar with the product structure and how the positions are held (directly or by borrowing).
Nonetheless, index funds can be criticized on several points. Firstly, equity funds specifically allow gamblers to be taken in relation to an index with the aim of outperforming it, while an index fund will at best achieve the same performance as the index.
Furthermore, because of their construction based on the market capitalization of companies, securities included in some indexes may represent a huge proportion, thereby biasing the homogeneity of the index. In some cases, a few securities may represent over half the index, as with the SMI (Swiss Market Index). An equally weighted index can be an attractive answer to the problem of market capitalization weighting, but investors have to accept a performance gap compared with the initial index.
Performance may also sometimes be inferior to that of equity funds for a given observation period. Moreover, when the cost of rebalancing is considered, tracker funds' performance can sometimes be lower than that of the index. Finally, some empirical studies have shown that securities included in an index perform less well than those excluded.
The choice of either a broad market index fund or a sector index fund is very important, as it will define the desired market exposure. A sector index fund may be more suitable as it is more selective than the market as a whole, or even a tracker certificate on a basket of securities, which ultimately amounts to stock picking.
It is also possible to use index futures contracts. These are standardized contracts between investors and a clearinghouse, with the advantage of being publicly traded and therefore highly liquid. Costs, moreover, are very low, with much lower minimum investment amounts than those for buying stocks or index funds directly.
In fact, only an initial margin need be deposited in a margin account, the size of which will depend on the volatility of the underlying security (generally between 5% and 15%). Profits and losses are calculated on a daily basis, using the “marking to market” process. At the end of each trading day, according to the future's price movement, the margin account is readjusted to reflect the gain or loss of the open position.
If the balance of the margin account falls below the maintenance margin requirement, the investor receives a margin call and must pay into the account to return it to the initial margin, or the broker will close the position.
In view of the above, we suggest combining the use of broad market or sector index funds or futures with a selection of individual securities, which amounts to adopting a so-called classic or improved “core-satellite” approach.
Risks Associated with Stocks
In view of the various risks listed below, it is difficult to maintain that volatility alone constitutes an appropriate measure of risk. In our view, stocks are risky assets by definition.
a) Total Risk
Generally speaking, total risk comprises the specific risk associated with shares in a particular company and market risk, which depends on macroeconomic conditions and fluctuations in the stock market in general. It is possible to reduce exposure to specific risk through diversification, leaving only market risk. Inadequate diversification can lead to concentration risk: for example, one stock representing 25% of a portfolio.
Moreover, it is essential to have an intelligent diversification strategy that helps minimize exposure to the same risks. This implies being fully aware of the portfolio's different positions. For example, judging by the number of securities, a portfolio made up of 25 financial stocks appears at first glance to be diversified, but in fact, remains strongly exposed to a particular sector.
However, too great a diversification may lead to overdiversification, which is expensive and may potentially reduce returns. Investors must find a good balance and, to do so, we suggest considering the following principles:
do not invest in a single asset class;
avoid very small positions in a portfolio that have a negligible impact on overall performance. Invest a minimum of 1%–2% in a position;
maintain sufficient diversification between industries and regions. Do not accept too much exposure to a single industry or particular region;
avoid large concentrations in a portfolio. In general, an individual position should not account for more than 10%. However, much depends on the type of product.
b) Risk Associated with Speculation
At this stage of our analysis, it is worthwhile for investors to consider what they are really buying when they acquire a stock. Besides the equity instrument giving them economic and social rights, and the potential income and capital gains, investors also acquire a certain number of risks that we will list below, including the risk associated with speculation.
Speculators, whose primary goal is short-term profit, constitute a specific category of investors. With improved access to information and the globalization of trade and financial markets, their number has increased considerably over the last few years. They aim to get rich quickly and easily by taking advantage of various opportunities that present themselves on the market.
Chartists—followers of technical analysis—often belong to this category. They try to predict market entry and exit points in the short term by analyzing graphs and their forms.
Investors, on the other hand, usually adopt investment strategies with longer time horizons, and take into account various factors to determine the attractiveness of an asset class and its prospects for future development. For them, graphical analysis is an additional decision-making tool.
When investing in stocks, investors must accept exposure to price fluctuations which, due in large part to speculators who enter and exit the market quickly, may prove to be considered in the short term. They must, therefore, be capable of holding a position for the time horizon they have set themselves.
In this analysis, we consider that market risk encompasses the risk associated with speculation. Any investor who buys a stock is, at the same time, buying a share in speculation over which they have very little influence. However, investors can attempt to profit from this, as we will see later. As Graham pointed out early on, “everyone knows that speculative stock movements are carried too far in both directions, frequently in the general market and at all times in at least some of the individual issues”.
If we take this analysis to the extreme by assuming that the share of speculation is very large, the market becomes a veritable casino manipulated by speculators, and the only factor that can generate returns is luck. In some markets, speculation is so strong that investors would be forgiven for wondering what exactly it is that they are buying.
The satisfaction that comes from stock betting would thereby replace satisfaction from returns, turning stock markets into giant lotteries or racecourses where the horses are stocks to gamble on. Some may believe that there is nothing random about this type of race and that only the best may win, but here we will let the investor or the gambler make up their own mind.
The profitability of casinos and gambling is generally very high, just like the exploitation of the stock market. One may sometimes wonder whether it is worth risking one's money by investing in the stock market, as the likelihood of significant losses is often greater than commonly believed.
Investors must be conscious of this. They must understand and analyze market mechanisms and the various stakeholders involved, all of which will have an influence on the price of their securities. Using the tools described below will help to limit the risk of losses.
c) Risk of Falling Stock Prices
When the stock market and stock prices fall, investors suffer a loss of value of the capital invested that can be significant depending on the size of the downturn. In the event that a decline is anticipated, it is possible to hedge against this risk in several ways.
i) Placing a Stop Loss Order
Investors may decide to set a price limit at which a sale order will be triggered. In the event of a sudden downturn, the final execution price may be lower than the stop-loss level, as the order is executed at the first available exit price. Investors should note that depending on the type of instrument and the market under consideration, it is not always possible to place stop loss orders.
Stop losses are free to place and easy to renew. However, once executed, they leave investors with cash although the drop may only be temporary. As we will see below, a put option, on the other hand, allows investors to profit if the price of their security recovers before the option expires.
ii) Buying a Put Option (Right to Sell)
This insurance has the advantage of eliminating risk asymmetrically, i.e., it protects investors against downside risk while allowing them to participate in rising markets.
Unlike stop losses, this insurance has a cost, which may be high depending on the option's strike price, time to expiration and volatility. The higher the coverage sought, the more expensive the put. Furthermore, as with all strategies using options, timing is an important aspect and future development is uncertain. It is possible to be right, but too early (the put expires too quickly) or too pessimistic (a correction does occur but the strike price is set too low).
Moreover, often only American options are available, which means having to pay more for the possibility of exercising the option at any time. Differences between the bid (sale price) and the ask (purchase price) are sometimes large and it is often difficult to master the costs of such a strategy.
iii) Sale of Futures Contracts
The sale of futures contracts lets investors reduce their exposure to stocks and thereby limit the loss of value of their investments in case of market downturns. In this case, they eliminate market risk symmetrically, that is, they hedge against any market downturn but do not participate in market upswings (in the case of complete hedging).
When a downturn is expected, they can sell a certain number of futures corresponding to the amount to be hedged. If the downturn does occur, the profit generated by the sale of contracts (closure of the position by buying back the same number of contracts) therefore compensates for the loss in value of the stock.
However, this strategy requires setting aside an initial margin and daily calculation of variation margins. Open futures contracts are marked to market daily, i.e., the process of evaluating gains or losses is carried out every day, and this can lead to margin calls. Consequently, investors must have enough cash to meet potential margin calls if the maintenance margin requirement is no longer met.
This strategy is certainly simple to set up, but investors must monitor the movement of futures prices carefully, and consider placing stop loss orders to limit losses on the futures contracts if the market were to move in the opposite direction.
Finally, this hedging strategy is often imperfect; the number of contracts is often rounded off, variations in stock prices do not necessarily correspond to the variation in the futures contracts and the expiry of the contract used does not always correlate to the time horizon of the hedge (basis risk). Therefore, the hedge is often partial and the futures contract used does not perfectly represent the positions held in the portfolio (correlation risk).
iv) Sale of Stock
If a strong decline is expected, it is better to sell the stock directly so as not to suffer the loss of value. Obviously, for investors who are unwilling to accept potential capital losses, and for whom preserving capital without risk of fluctuation is essential, this asset class should not be considered.
d) Liquidity/Solvency Risk Associated with Stocks
Liquidity risk is the risk that a company will no longer be able to meet their short-term financial commitments, such as interest payments, principal repayments, payment of suppliers, etc.
It is difficult for investors to hedge against this type of risk, but before investing, examining the ratios used to measure short-term liquidity may prove useful. The most commonly used in practice are the current ratio, which generally should be higher than 2, or the quick ratio, which should at least be equal to 1 to be sure that the company has enough cash and liquid assets to cover their short-term debts.
It is important to be able to monitor the movement of these ratios over a three to five-year period and to know their average value for the industry the company operates in so that comparisons can be made. A short cash cycle will not pose any cash flow problems, while a longer cycle may, clients paying their invoices too slowly in relation to the payment of supplier invoices by the company. Cash is therefore essential for its survival, as even if it is making a profit, a company can go bankrupt if it lacks cash.
Long-term solvency risk is the risk that a company will not be able to meet its financial obligations in the long term, which can ultimately lead to the company going bankrupt.
Once again, it is difficult for investors to hedge against this type of risk, but examining the ratios used to measure long-term solvency may prove useful before investing. The debt ratio and the interest coverage ratio are the most commonly used in practice. Here again, it is important to be able to monitor their movement over a three to five-year period and to know their average value for the industry the company operates in, so that comparisons can be made.
For example, looking at changes in the debt ratio of the former airline Swissair between 1997 and 2000, we can see that it went from 3.76 to 13.95, a progression that should immediately have discouraged any potential investor.
e) Bankruptcy Risk Associated with Stocks
This is the ultimate risk associated with the company's future survival. In the event of bankruptcy, stockholders can only hope to recover a share in the proceeds of liquidation.
It is difficult to hedge against this type of risk, apart from avoiding investment in stocks altogether. Examining the various ratios indicated above and a more comprehensive analysis of the company's operations both help limit exposure to this risk. Nonetheless, it is associated with any stock investment.
f) Operational Risk of the Company
Human error, fraud, corruption, exceptional expenditure and the loss or unavailability of employees or managers are operational risks that can prove to be significant or even catastrophic for a company.
Investors holding shares in a company are obviously powerless to control these risks, making it practically impossible to hedge against such consequences. There are hazards and, unfortunately, black sheep in every profession, but exposure to this risk can be limited by swift reactions to news and rumors circulating about companies held.
g) Reputation Risk Associated with Stocks
This risk relates to events that affect the company's image (defective products, court cases, reputation in the industry, with clients or suppliers, etc.). It is difficult for investors to hedge against this type of risk, but this factor must also be considered as part of the investment process. Following news related to the company again helps limit this risk.
h) Risk Related to the Economic Environment/Industry Risk
Macroeconomic conditions, the economic climate and the various seasonal or economic cycles obviously have an influence on companies. Interest rate movements, changes in growth and unemployment rates or commodity price movements affect various industries and therefore companies directly. The degree to which companies are affected and react will vary from one industry to another.
It is difficult for investors to protect themselves against this type of risk, but a detailed analysis of macroeconomic conditions, the relevant industry, and future prospects help to limit it and to find an appropriate position within this asset class.
i) Political Risk Associated with Stocks
A lack of political stability in a country can affect assets held within it and have an impact on the companies operating on that soil. This risk is more manifest in emerging countries. Economic conditions can also incite governments to make decisions that affect particular industries and their long-term profitability.
It is difficult for investors to hedge against such a risk, apart from avoiding investing in stocks in emerging countries. Taking this factor into consideration can help select stocks with a low political risk by turning to the developed markets.
j) Legal/Regulatory Risk Associated with Stocks
The legal and regulatory framework defines the limits of a company's operations and any modification can have significant consequences. Changes in Swiss bank secrecy and their consequences for banks are a prime example.
Once again, apart from belonging directly to a major lobby, it is difficult for investors to protect themselves against this risk, but taking these factors into account during the process of investment in an asset class, a sector or a particular security helps limit exposure to it.
k) Risk Associated with Emerging Countries
Besides political and liquidity risk, it is often difficult for investors to obtain information about a company operating in an emerging country. In addition, there are often restrictions on foreign investment and stakes in these companies. Finally, transaction costs are often very high and can sometimes be ten times higher than those paid on the American or English markets.
On this type of risk, please refer to indications given above for bonds.
l) Monetary Risk Associated with Stocks
Some countries may pursue monetary and fiscal policies leading to higher inflation, interest rates, borrowing costs and, ultimately, a recession. This can also have an impact on the domestic currency.
A weak currency favors exports, but penalizes imports, while a strong currency penalizes exports and favors imports. Therefore, the impact will vary according to the company's business activities and whether it is import or export focused. Investors have difficulty hedging against this type of risk, but their decision to focus on export or import companies should depend on their expectations for currency movements.
m) Currency Risk Associated with Stocks
In the case of investments in a foreign currency, i.e., other than the reference currency, exchange rate fluctuations can have a significant impact on the final return.
i) Hedging Currency Risk
Exchange rate movements are virtually unpredictable; the best forecast for tomorrow's rate (and the following days') is today's exchange rate. In the short term, partly because of the considerable number of speculators and stakeholders, it is very difficult to forecast exchange rate movements. An established trend may continue until a turnaround, but further, than that, any forecasting is very problematic.
However, many experts recognize that currencies tend to follow a “mean reverting process”. In other words, even if the price deviates over short periods from the long-term mean (which may itself change), in the end, the net result should be neutral. Over short periods, however, the impact can be significant.
The time horizon and the asset's holding period may provide some clues as to whether it is worth hedging or not.
If investors intend to hold the asset for a short period, they should consider hedging against short-term exchange rate fluctuations, which can impact significantly on returns. On the other hand, if investors intend to keep certain investments for a very long period, hedging against currency risk may not be necessary.
In the long term, although it undergoes fluctuations, the average performance of the exchange rate can approach zero and only the performance of the asset will have been decisive. However, even in the case of long-term asset holding, it may be feasible to hedge at certain times against currency risk and not at others, wagering on both the asset rise and appreciation of the foreign currency.
In practice, if investors have no particular conviction about a currency, they will remain neutral. If they are comfortable taking the risk of foreign currency fluctuation, they will not hedge. On the other hand, if they do not want to be exposed to this risk, they will ensure the position is hedged appropriately, in order to focus solely on the asset's return. In case of a strong conviction, they will hedge if they expect the investment currency to weaken.
The question of what proportion to hedge (100%, 50% … of the position?) will again depend on the degree of conviction and the risks investors are willing to take. The volatility of the asset class should also be considered. Certainly, for bonds, seeking an additional 1%–2% return while risking a currency loss of 3%– 4% seems unjustified. It may be useful to compare the volatility of the currency with the volatility of the asset class. The use of limits or stop losses helps limit the risk of losses.
The use of forwarding exchange contracts as a hedging instrument provides protection against the currency risk associated with positions in foreign currency, and investments in the investor's reference currency avoid this risk entirely.
Finally, some consider currency as an asset class in itself or as a form of diversification that must be managed accordingly. We will leave this question open but, in our view, investors must first decide what to invest in and then contemplate whether the investment currency is worth hedging. Investors can also limit their exposure to this risk by investing in their reference currency.
According to the efficient market hypothesis, the price given by the market is always the fair price and fully reflects all available information.
“A market in which all available information is immediately reflected in the price of securities offers no opportunity for arbitrage. It is therefore difficult to beat the market with any consistency, making passive management the best choice.” Because the price is given efficiently by the market, any opportunity to generate excess returns will immediately be eliminated by a large number of market participants. Therefore, it is impossible for any investor to outperform the market in the long term.
“Conversely, if the information is not always correct nor immediately reflected in prices, this means there are pockets of inefficiency that may be exploited as part of an active portfolio management strategy.”
Weak Form Market Efficiency
“A market is weak form efficient if prices incorporate all past information.” All past information is reflected in the current price, making it impossible to predict future price movements based on past prices.
Many studies conducted using technical analysis methods (filters, moving averages) have reached the conclusion that after factoring in transaction costs, it is not possible to beat the market with any consistency.
Weak form efficiency also implies that the returns on securities are independent of one period to another, as information is immediately included in the price. However, many tests invalidate the hypothesis of serially independent returns.
Empirical studies, in particular by Bondt and Thaler (1985), have demonstrated that investors “overreact”, tending to favor securities that are the subject of good news to the detriment of securities associated with bad news. Evidently, weak form efficiency does not enjoy unanimous support.
Semi-Strong Form Market Efficiency
“A market is semi-strong form efficient if prices incorporate all past and public information. According to this definition, it is impossible to make any excess gains by trading on earnings, dividend or stock split announcements, etc., as this information can be used by anyone once it is made public.” Event studies can be used to determine different price reactions following the release of information.
Prices may adjust immediately, thus implying that the market is efficient. However, when the price takes some time (several days or even months) to incorporate the information, this is referred to as under- or overreaction that can be exploited by investors.
Most studies show that investors react quickly, and that it is illusory to hope to make excess returns by trading on information such as dividend announcements, bonus share issues, stock repurchases, acquisitions, mergers, changes in accounting policies, etc. Nonetheless, some recent results show slow adjustment to events such as earnings announcements.
We will examine investors' under- and overreaction to information in more detail at a later stage. At this point, we can assume that all publicly available information is not immediately reflected in prices, implying a certain level of market inefficiency.
Strong Form Market Efficiency
“Finally, a market is strong form efficient if prices incorporate all past, public and private information. In this case, it is impossible to earn returns in excess of the market using insider information.”
However, in practice, the existence of insider trading invalidates this form; “abnormal” profits can be generated although this constitutes an illegal practice. Independently of any possibility of insider news, so-called pockets of inefficiency may exist. These take time to be corrected and to return to a situation of market equilibrium and efficiency.
Furthermore, “information is not a free resource; it entails acquisition costs that may be high. This is the case for many tools and services used by portfolio managers and traders. So this cost must be included in the definition of efficiency, particularly for testing the strong form. It was Grossman and Stiglitz (1980) who showed that prices should not perfectly reflect information.”
Thus, “an investment fund, which requires constant information processing, must make a return in excess of the average market return to compensate for the cost of this information. If the fund's return exceeds market return and management costs, the market may then be considered inefficient.”
Of course, there are fund managers who succeed in beating the market after deduction of transaction costs, but they are unable to do so repeatedly, year after year. While the important role played by luck must not be forgotten, exploitation of these pockets of inefficiency should be considered.
Conclusion on Market Efficiency
According to this very strong assumption, variations in yesterday's prices do not influence today's prices, nor do they influence tomorrow's, so that each variation is independent of the last. According to studies by Mandelbrot, in particular, it seems that prices have a sort of “memory” and that sometimes the market needs time to assimilate information and reflect it in prices.
Warren Buffett liked to joke that he would willingly subsidize university chairs on efficient-market hypothesis so that professors could educate increasing numbers of misguided financiers whom he could then fleece.
As Mandelbrot summarises, “efficient market hypothesis is nothing more than that, a hypothesis”. Graham already believed in his time that “when the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
Algorithm: A set of rules for accomplishing a task in a certain number of steps. One common example is a recipe, which is an algorithm for preparing a meal. Algorithms are essential for computers to process information. As such, they have become central to our daily lives, whether ordering a blog online, making an airline reservation or using a search engine.
Algorithmic Trading: A trading system that utilizes very advanced mathematical models for making transaction decisions in the financial markets. The strict rules built into the model attempt to determine the optimal time for an order to be placed that will cause the least amount of impact on a stock’s price. Large blocks of shares are usually purchased by dividing the large share block into smaller lots and allowing the complex algorithms to decide when the smaller blocks are to be purchased.
Ask Price: The price a seller is willing to accept for a security, also known as the offer price. Along with the price, the ask quote will generally also stipulate the amount of the security willing to be sold at that price.
Backtesting: The process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge its effectiveness.
Base Currency: The first currency quoted in a currency pair on forex. It is also typically considered the domestic currency or accounting currency. For accounting purposes, a firm may use the base currency to represent all profits and losses.
Bid Price: An offer made by an investor, a trader or a dealer to buy a security. The bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased.
Carry Trade: A strategy in which an investor sells a certain currency with a relatively low-interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.
Commodity Futures Trading Commission (CFTC): An independent U.S. federal agency established by the Commodity Futures Trading Commission Act of 1974. The Commodity Futures Trading Commission regulates the commodity futures and options markets. Its goals include the promotion of competitive and efficient futures markets and the protection of investors against manipulation, abusive trade practices, and fraud.
Drawdown: The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the trough.
Fiat Currency: Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be”.
Forex: The exchange of one currency for another or the conversion of one currency into another currency. Foreign exchange also refers to the global market where currencies are traded virtually around-the-clock. The term foreign exchange is usually abbreviated as “forex” and occasionally as “FX.”
Forward Testing: Forward testing is a simulation of actual trading and involves following the system’s logic forward to gauge its effectiveness in live market conditions.
Fundamental Trading: A method of evaluating a currency that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the currency’s value, including macroeconomic factors (like the overall global economy and conditions) and country-specific factors (like economic and financial conditions).
Geometric Average Holding Period (GHPR): The geometric average return formula is used to calculate the average rate per period on an investment that is compounded over multiple periods. The geometric average return may also be referred to as the geometric mean return.
Gold Standard Currency: A monetary system in which a country’s government allows its currency unit to be freely converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic difference for an ounce of gold between two currencies. The gold standard was mainly used from 1875 to 1914 and also during the interwar years.
High-Frequency Trading (HFT): A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2009, it is estimated more than 50% of exchange volume comes from high-frequency trading orders.
Interbank Market: The financial system and trading of currencies among banks and financial institutions, excluding retail investors and smaller trading parties. While some interbank trading is performed by banks on behalf of large customers, most interbank trading takes place from the banks’ own accounts.
Leverage: The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
Margin: Borrowed money that is used to purchase currencies or equities. This practice is referred to as “buying on margin”.
Margin Call: A broker’s demand on an investor using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin. Margin calls occur when your account value depresses to a value calculated by the broker’s particular formula.
Momentum Indicator: The Momentum Technical Indicator measures the amount that a security’s price has changed over a given time span.
Moving Average: A widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random price fluctuations. A moving average (MA) is a trend-following or lagging indicator because it is based on past prices.
The two basic and commonly used MAs are the simple moving average (SMA), which is the simple average of a security over a defined number of time periods, and the exponential moving average (EMA), which gives a bigger weight to more recent prices. The most common applications of MAs are to identify the trend direction and to determine support and resistance levels. While MAs are useful enough on their own, they also form the basis for other indicators such as the Moving Average Convergence Divergence (MACD).
National Futures Association (NFA): The independent self-regulatory organization for the U.S. futures market. NFA membership is mandatory for all participants in the futures market, providing assurance to the investing public that all firms, intermediaries, and associates who conduct business with them on the U.S. futures exchanges must adhere to the same high standards of professional conduct.
The NFA operates at no cost to the taxpayer, as it is financed exclusively by membership dues paid by members and assessment fees paid by users of futures markets. The national headquarters is in Chicago and there is an office in New York.
Net Asset Value (NAV): The balance of deposits, realized and unrealized profit/loss, and interest, minus withdrawals.
Over-the-Counter (OTC) Market: A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase “over-the-counter” can be used to refer to stocks that trade via a dealer network as opposed to a centralized exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network.
Pip: The smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100 of one percent or one basis point.
Price Action: The movement of a security’s price. Price action is encompassed in technical and chart pattern analysis, which attempt to find order in the sometimes seemingly random movement of price. Swings (high and low), tests of resistance and consolidation are some examples of price action.
Profit Factor: The profit factor is defined as the gross profit divided by the gross loss (including commissions) for the entire trading period. This performance metric relates the amount of profit per unit of risk, with values greater than one indicating a profitable system.
Profitability: A regulation for evaluating whether to proceed with a project or investment. The profitability index rule states: If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below 1, the optimum course of action may be to reject or abandon the project.
Quantitative Trading: Trading strategies based on quantitative analysis, which rely on mathematical computations and number crunching to identify trading opportunities. Price and volume are two of the more common data inputs used in quantitative analysis as the main inputs to mathematical models.
As quantitative trading is generally used by financial institutions and hedge funds, the transactions are usually large in size and may involve the purchase and sale of hundreds of thousands of shares and other securities. However, quantitative trading is also commonly used by individual investors.
Quote Currency: The second currency quoted in a currency pair in forex. In a direct quote, the quote currency is the foreign currency. In an indirect quote, the quote currency is the domestic currency.
Risk Capital: Investment funds allocated to speculative activity. Risk capital refers to funds used for high-risk, high-reward investments such as junior mining or emerging biotechnology stocks. Such capital can either earn spectacular returns over a period of time or may dwindle to a fraction of the initial amount invested if several ventures prove unsuccessful. Diversification is key for the successful investment of risk capital. In the context of venture capital, risk capital may also refer to funds invested in a promising start-up.
Risk: Reward Ratio: A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount he or she stands to lose if the price moves in the unexpected direction (i.e. the risk) by the amount of profit the trader expects to have made when the position is closed (i.e. the reward).
Sharpe Ratio: A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
Signal: A sign, usually based on technical indicators, that it is a good time to buy or sell a particular security. Trade signals come in a variety of forms, including bull or bear pennants, rectangles, triangles, and wedges, as well as head-and-shoulders chart patterns. Trade signals may also bring attention to abnormal volumes, options activity, and short interest.
Stop Loss: An order placed with a broker to sell a position when it reaches a certain price. A stop-loss order is designed to limit an investor’s loss on a position.
Technical Analysis: The academic study of historical chart patterns and trends of publicly traded stocks. Technical analysis of stocks and trends employs the use of tools such as bar or candlestick charts and trading volumes to determine the future behavior of a stock. Much of this practice involves discovering the overall trend line of a stock’s movement.
Trader Psychology: The emotions and mental state that dictate success or failure in trading securities. Trading psychology refers to the aspects of an individual’s mental makeup that help determine whether he or she will be successful in buying and selling securities for a profit. Trading psychology is as important as other attributes such as knowledge, experience, and skill in determining trading success.
Discipline and risk-taking are two of the most critical aspects of trading psychology since a trader’s implementation of these aspects are critical to the success of his or her trading plan. While fear and greed are the two most commonly known emotions associated with trading psychology, other emotions that drive trading behavior are hope and regret.
Trading the News: A technique to trade equities, currencies and other financial instruments on the financial markets. Trading news releases can be a significant tool for financial investors. Economic news reports often spur strong short-term moves in the markets, which may create trading opportunities for traders.
Interest rates, unemployment and export rates, or the central bank’s policy shifts can cause a deep change of an exchange rate.
Trailing Indicator: A technical indicator that trails the price action of an underlying asset, and is used by traders to generate transaction signals or to confirm the strength of a given trend. Since these indicators lag the price of the asset, a significant move will generally occur before the indicator is able to provide a signal.
Trend Reversal: A change in the direction of a price trend. On a price chart, reversals undergo a recognizable change in the price structure. An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows. A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.
Brokers who deal with options traders
Of course, you’ll need a brokerage account to trade options. However, you also will deal with many other institutions that have a critical role in developing options, ensuring that trades clear, and regulating the industry. This blog gives you an overview of these institutions and how they work together to keep the options markets functioning smoothly.
Keep in mind that the financial services industry has been going through a lot of upheaval in recent years. Tons of mergers, acquisitions, start-ups, and other changes may make some of the information in this blog outdated almost as soon as I type it, let alone by the time you read it. That’s part of the creativity of the industry.
Pricing and Trading Structures for Options
The main point of competition for many of the exchanges is how they handle orders after the brokers submit them. For the most part, this matters more to an institutional investor than to an individual. Still, it’s good to know how orders are handled after the broker submits them, both to understand how the market works and how it might change.
Many years ago, traders used paper noteblogs to keep track of orders. Orders are handled electronically now, but the record is still referred to like the blog.
The Role of Market Makers
Market makers are members of an exchange who agree to place a bid on every order that is entered. Each market maker works with a different set of options. They don’t have to place a bid at a price the customer wants, but they do have to be involved in the market. Some market makers are self-employed, most are part of firms that specialize in this aspect of the business, and some are associated with brokerage firms.
A trader who is in the business of ensuring that there are buyers and sellers for a particular option is known as a market maker. If no orders come from the public, the market maker will take the trade. Most market makers then hedge their positions.
Here’s what they do: if someone wants to buy a Jan (short for January in standard options lingo) call on XYZ Company, a market maker has to make an offer to sell. The market maker doesn’t have to sell at any price, but the offer has to be made.
This is an important function. Market makers ensure there is some liquidity in the market. They ensure someone will take an order and there’s a price out there that can be used to determine the value of a given option. Prices carry information, and that helps make the options markets efficient, which means people are willing to turn to it to manage risk. Without the market making function, there would be nothing for speculators to trade.
Most market makers are hedgers rather than speculators because they are taking on risk from their market-making activities. They will make trades elsewhere to protect their business, which is another way they create liquidity.
The Order of Trade
Orders come into the exchanges constantly. There are enough conflicts among them that the exchanges need to set a system to determine which orders are executed first and who pays the exchange.
Here are the different methods exchanges use to handle orders:
Customer priority If two orders come in at the same price, the customer orders are executed before orders placed by market makers. Market makers pay transaction fees; customers don’t.
Maker-taker Under this model, the market maker—the one who “makes” the orders—pays no transaction fee while the customer—who “takes” the orders—does. Price-time priority entered earliest at a fee.
Orders are given timestamps when they are submitted to the exchange. The order given price is executed first, and the person placing the order pays the transaction
Pro rata allocation Orders with the same priority are filled on a proportional basis if they can’t be filled completely.
Size allocation Orders with the same priority are filled largest to smallest.
The transaction fees usually run about $0.20 or $0.30 per lot of 100 options. It’s a small fee, but it can add up on large orders or for frequent traders.
Price improvement means the customer pays less to buy an option or receives more to sell it than the order that was placed. It’s a good thing, and some options exchanges promote the ability to receive price improvement as a way to differentiate themselves.
If the market moves as an order is entered, price improvement might occur naturally. Customers placing large orders often want price improvement. In that case, the broker will request it, and the trade will go through an auction process. Market makers can choose to take all or part of the order at a better price. Price improvement isn’t likely on retail orders or even on most institutional orders.
Where to Trade Options
Most options trade on organized exchanges. Unlike stocks and bonds, options are created by the exchanges where they trade and not by the underlying companies. This means the features, benefits, and rules governing different types of options might be specific to the exchange that issued the option. The exchanges were once physical locations in impressive downtown locations, but now they are often nothing more than server farms.
Once a national exchange issues an option, it might be traded on many other exchanges. In exchange lingo, these are fungible, multiple-listed options. Some exchanges may have more trading volume, offer better pricing, or allow different order types than others. These differences might matter to your trading strategy or the particular option you want to trade.
Options Exchanges in the United States
Exchanges exist all across the United States. Here are the top ones:
BATS Options Market The BATS (Best Alternative Trading System) market was set up to offer better execution for common stock. The company’s options exchange, also known as BZX, handles orders on a price-time priority basis. The company has recently announced a new options exchange, EDGX, which accepts orders on a customer priority/pro rata allocation basis.
The difference is important to institutions placing large orders via electronic systems, and this is an example of how competition among the exchanges is leading to services that meet the specific needs of some traders.
BOX Options Exchange This exchange was set up to allow brokers to connect directly with its network. It offers a price-improvement period during the order execution that is designed to mimic the benefits of open outcry trading.
C2 Options Exchange C2 is an all-electronic exchange started by the CBOE. It uses a price-time order structure. Chicago Board Options Exchange The CBOE is the first and largest of the options exchanges. However, it is no longer the only game in town. The exchange has two key advantages, however:
It develops most of the options products traded here and on other exchanges.
It still offers open outcry trading for many of its products, which many in the industry argue allows for better execution of large trades.
Although the CBOE has competition, it continues to set the tone for the rest of the industry.
CME Group Once known as the Chicago Mercantile Exchange, the CME Group is a holding company for many niche futures exchanges. These exchanges also trade options on futures, which are options based on the price of other derivatives contracts. CME Group is comprised of four markets:
The Chicago Mercantile Exchange, also known as the CME or the Merc, handles options on equity indexes, foreign exchange, and some agricultural commodities.
The CBOT, or the Chicago Board of Trade, specializes in agricultural options and options on interest rates. The New York Mercantile Exchange, or NYMEX, offers options on gas, oil, and other energy commodities as well as some metals. COMEX, once known as the New York Commodity Exchange, has options on many different metals contracts.
The Intercontinental Exchange (ICE ) Also known as ICE, the Intercontinental is owned by the New York Stock Exchange (NYSE) and specializes in energy, metals, and environmental derivatives. It is mostly a futures and physical exchange, but it offers some options, and it handles over-the-counter transactions. ICE also offers contracts on unusual assets and has shown much willingness to experiment.
International Securities Exchange (ise.com ) The International Securities Exchange, or ISE, introduced the first all-electronic options exchange in the United States in 2000. It uses a customer-priority, pro rata (or proportional) market structure. The company also operates a separate options exchange, ISE Gemini, which uses pure maker-taker pricing. Most of the offerings are traditional equity options, but the ISE folks have been willing to experiment with options on such things as cybersecurity.
Over-the-counter (OTC ) options do not trade on an organized exchange. Instead, they are issued by brokers and rarely have a secondary market. These are sometimes known as exotics because they cover unusual assets or situations, often customized to meet a specific customer’s needs.
Over-the-counter (OTC) options are options that do not trade on an organized exchange. They’re often customized by a broker to meet a particular customer’s needs. As an options trader, you might never come across an OTC option, but it’s nice to know that they exist.
Finding a Broker
Options trades are executed by brokerage firms, and almost all of them handle options trades. However, that doesn’t mean just any firm will be able to meet your particular needs. The occasional options trader might not need to shop around, but someone who is day trading options or who plans to make a significant number of trades should check into different features that distinguish options brokers from the rest. The benefits in information and execution could be significant for you.
Some brokers use different brand names for their options trading services than their primary business. For example, TD Ameritrade’s options brokerage is known as thinkorswim. The difference is usually related to the types of trading platforms (discussed later in this blog) available to different types of customers.
DID YOU KNOW?
Most brokers allow you to open a free demo account to let you test their services with play money. How important the different features depending on your own needs. The following sections highlight different features to help you comparison shop.
Commissions and Trade Execution
Brokerage firms charge commissions to make trades. That’s fair because they have to make money. Traders often fixate on the pretrade commission's different brokers charge, but it is only part of what you pay. You also pay any exchange fees, and then there’s the price at which you buy or sell. Would you rather buy at a lower price or pay a lower commission? As a customer, you should look for the lowest overall price, especially if you will be trading options on a regular basis. The commission is just one part of the price.
Many brokers have different fee schedules based on how much money you keep in your account or how many trades you place. Keep that in mind as you check out different firms.
The discussion of the exchanges earlier in this blog included information about different pricing and priority structures. They often include tradeoffs between, say, paying an exchange fee and receiving priority in execution or getting a better price and having the order executed right away. Brokers must disclose information about trade execution prices and speeds once a quarter, so you can get that information to make comparisons.
Some brokerage firms don’t charge commissions. That doesn’t mean their services are free. They will be passed on to you in other ways, usually in the form of worse execution from their own market makers. When evaluating firms, look at the total cost of trading, and not at any one line item.
Brokerage firms have to manage their own risks, and one way they do this is by setting limits on what customers are able to do in their accounts. The broker might set a position limit, for example, which is the maximum number of open contracts an investor can hold in one account. This might be expressed in terms of a number of contracts on one side of the market or in terms of total long or total short delta. If you plan on being an active trader, you’ll want to check on this.
A position limit is the maximum number of contracts any one account holder can have in the same underlying asset. It may be set by either the exchange or the brokerage firm.
Choosing a Software Platform
Active traders often make decisions based on the information on their computer screens. Hence, the software offered by the brokerage firm is really important. Later in the blog, I cover information about different types of research and services people use. For now, though, compare brokerages based on the following:
Additional fees for the use of software
Sources of real-time price quotes
Most active traders find that the platform is more important than the other aspects of the broker’s services, so be sure to look for a system that works for you.
Futures Commission Merchants
Most options trade through regular brokers, but some types of derivatives don’t. If your trading strategy will include futures contracts, options on futures contracts, retail off-exchange foreign exchange, or swaps, you’ll need to trade through a futures commission merchant (FCM), a broker registered with the futures exchanges. Many FCMs are the same brokers who also handle stocks and options, but not all stockbrokers are FCMs.
A future is similar to an option in that it allows you to buy or sell something at a date in the future at a price agreed upon today. The big difference is that a futures contract must be exercised if it reaches expiration, so most futures contracts are closed out with an offsetting transaction before expiration hits. An option on a future is a way to get exposure to the price change of the underlying asset without actually having to buy or sell.
Signing the Options Agreement
In order to trade options—in your existing brokerage account or a new one—you need two pieces of information on file to ensure you understand the risks of options trading and can cover them:
The margin agreement covers the borrowing of funds inherent in options trading. The options agreement covers all the information about the risks of options trading, as well as details about any limits that may be placed on your account and information about exercise assignment. Not all options strategies are risky, but a few have the potential for huge losses, and the brokers aren’t taking chances.
The margin agreement is the contract a customer signs with a brokerage firm that states he or she understands the risks and costs involved with margin. The options agreement is the contract a customer signs with a brokerage firm in which the customer acknowledges receiving a guide to options from the broker and understands the risks and fees involves with trading options.
Other Institutions in the Options Game
The options industry has its own set of regulators and related organizations that oversee the industry. They have their own rules and quirks, and you might not know much about them if you are new to options trading. Some of these organizations were invented to handle aspects of options trading that are different from stock and bond trading.
Options Clearing Corporation
The Options Clearing Corporation (OCC) ensures that options trade clear. This means they guarantee that options orders go through and options exercise takes place as contracted. A key part of the OCC’s job is setting and enforcing margin requirements. It also operates the centralized system used by clearing brokers to help the system work efficiently.
The clearing brokers, or clearing members, are the people who handle the transactions involved. They guarantee that a market maker will deliver on his or her trades. Clearing brokers also provide different cash management and account services. The OCC itself doesn’t make transactions, but it oversees the work that takes place.
Options Industry Council
Whether you are new to options trading or want to keep current on all the new products, the Options Industry Council (OIC) is your best friend. This industry-sponsored organization offers educational programs about options at every level: speculation, hedging, beginner, advanced, retail, and institutional. Its purpose is to help people be successful with options trading so they will keep it up.
At the OIC website, Home, you’ll find lots of webinars, courses, publications, and other information to help you learn about options and refine your strategies.
The options industry is highly regulated. To complicate matters, different types of options are handled by different types of regulators. That will probably change someday, but not in time for my deadline on this manuscript.
The first line of regulation is made up of the exchanges themselves. They determine which firms are allowed to trade with them and what practices they must follow. Beyond that, many different governments and industry regulators are involved:
U.S. Commodity Futures Trading Commission The first equity options exchange, the CBOE, was founded by the CBOT, which specializes in agricultural futures contracts. This organization, also known as the CFTC, oversees the commodity exchanges. Given that options on futures, swaps, and other derivatives contracts trade on the commodity exchanges, the CFTC plays a role in the options market.
Financial Industry Regulatory Authority The Financial Industry Regulatory Authority, or FINRA, handles the licensing of brokerage firms and their personnel. This is not a government agency, but rather an organization made of people in the financial industry. It works closely with the Securities and Exchange Commission (SEC).
National Futures Association This private organization, also known as NFA, works closely with the CFTC to regulate the futures exchanges, and that includes exchanges that handle options on futures. It provides licensing examinations for futures commission merchants and their personnel.
U.S. Securities and Exchange Commission Knew as the SEC, this government agency oversees the operations of stock and bond exchanges as well as exchanges that trade options on stocks and bonds.
Just as with options, futures contracts are derivatives. They derive their value from the price of something else. They are standardized contracts traded on organized exchanges, used by both hedgers and speculators. They are valued based on the price of the underlying asset, the exercise price, the expiration date, interest rates, and the volatility of the underlying asset—the same as options.
However, one key difference is the holder of a futures contract carries the obligation to buy or sell. An option holder does not have this same obligation. Futures are sometimes used in conjunction with options as part of a trading strategy.
Futures contracts are one of the most common types of derivatives. Along with options, they are standardized and trade on organized exchanges. In fact, the options market is an outgrowth of the futures market.
A futures contract is an obligation to buy or sell a predetermined amount of a given item at a future date, and at a price determined today. The big difference between a future and an option is that with a futures contract, you must buy or sell if you hold the contract until expiration. (Most futures contracts are closed out with an offsetting position prior to expiration, so buying cattle futures doesn’t mean a bunch of cows will show up in your backyard.)
In some cases, the settlement of the future is in cash, meaning the buyer and seller exchange the cash value of the item involved. In other cases, though, the settlement is in the physical asset.
Futures contracts are standardized by the exchanges. The contracts are traded in preset amounts, and they have set expiration dates. Traders use a clearinghouse account in order to mark to market.
Mark to market is the process of updating the value of trading accounts at the end of the day to reflect the official closing price for the day.
When trading closes for the day, the futures clearinghouse (the organization that manages the money for the exchange) will value all traders’ accounts to reflect the official price at the end of the trading session, also known as the settlement price. (This is usually the price of the last sale.) The process is known as marking to market, and it is a key way to ensure traders have the money to settle up when expiration occurs. After all, if they have to come up with a little money every night, they can’t be in denial about the value of their position.
Almost all futures contracts are closed out before expiration with an offsetting trade. Someone who is long a future sells an identical contract to close out the position, for 0 net exposure to the asset price.
Types of Futures Contracts
The futures markets were established to create markets for agricultural commodities, and that’s still a large component of the market. Grain, cattle, and pork bellies (yes, that’s a thing, it’s the futures market for bacon) trade electronically these days, rather than on the floor of the Chicago exchanges.
Over the years, the futures markets expanded to include financial futures. The market now has futures on currencies, interest rates, and market indexes. They often trade in mini-sized contracts, which are smaller value positions for individual investors.
Options on Futures
The futures market has expanded to include options on futures, a way to trade options on agricultural commodities and currencies. These trade like other options. The difference is the value is drawn from the value of another derivative, rather than the value of the asset itself. The settlement is in cash, not the underlying asset.
A forward contract is similar to a futures contract. Both involve a commitment to exchange an item at a date in the future at a price determined today. The difference is a forward contract is not standardized.
People often use forwards in their lives. A simple example is making a hotel reservation. You agree today you will receive the use of the room in the future, at a price agreed upon today. You then use your credit card to guarantee that settlement.
Some types of forwarding contracts trade amongst institutional investors in the over-the-counter market. For example, banks might trade different currency forward contracts. As an independent options trader, it is unlikely you will be working in forwarding contracts.
One of the more interesting derivatives markets is in environmental credits. It started in 1990 under an amendment to the Clean Air Act. The goal was to reduce the amount of sulfur dioxide electric utilities could emit in order to reduce the incidence of acid rain, an effect of pollution that damaged trees. Each utility was given a number of allowances for pollution.
A utility could use those or sell them to another utility. If a utility emitted more sulfur dioxide than it was allowed, it could either spend money on technology to reduce the emissions or buy more credits from other utilities. Thus, a utility didn’t have to make changes; it had alternatives to consider.
And alternatives add value.
This system, called cap and trade, was a huge success—so much so people figured it would be used for other types of pollution. For whatever reason, that didn’t happen.
That being said, there is a voluntary market in environmental credits, the Chicago Climate Exchange, operated by ICE. It can be expanded at any time regulators in the U.S. or elsewhere establish a new cap and trade program—and that creates a potential opportunity for traders.
A swap is a contract that allows someone to trade one type of contract for another. For example, suppose you have a floating rate bond, and you’d rather receive fixed interest payments. Someone else has a fixed-rate bond but would rather receive floating rate payments. You swap your payments, and everyone is happy.
Currency swaps allow two parties to trade commitments to pay in one currency for another. This is a way to manage exchange-rate risk and to get around problems of currency controls, which is an issue in some emerging markets.
Interest Rate Swaps
Interest rate swaps are usually exchanges of fixed-rate payments for floating-rate payments. They are based on a predetermined amount of principal, called the notational principal amount. Only interest payments are exchanged, not the underlying. This can help portfolio managers hedge interest rate risks.
Commodity swaps are contracts based on the price of an underlying commodity. They are similar to futures contracts in that they allow parties to lock in the price of a sale. These are useful for commodities that are not covered by exchange-traded futures contracts.
A swaption is an option on a swap. Clever, huh? A payer swaption gives the holder the right, but not the obligation, to enter into an interest rate swap at a predetermined fixed rate at a predetermined time. A receiver swaption gives the purchaser the right, but not the obligation, to receive fixed payments at a predetermined time.
Collateralized Debt Obligations
A collateralized debt obligation isn’t a true derivative, but it is often included in lists of derivatives. It’s a bond issued against a pool of loans. A bank or mortgage company collects a group of loans and then sells bonds on it. The loans might be mortgages, car loans, credit card debts—anything that generates cash flow.
Instead of the lender keeping the principal and interest payments it receives, it passes shares of those onto the bondholders. In a sense, the bond buyers are receiving payments derived from the value of the underlying loans. Collateralized debt obligations are also the reason for the development of another type of derivative, the credit default swap, as buyers were looking for a form of insurance.
Credit Default Swaps
Credit default swaps, also known as CDSs, are contracts in which a bondholder ensures the position against default by the issuer. If the bond goes into default, the seller of the swap must pay the buyer the funds. In exchange, the seller keeps the premium. These contracts than trade over the counter. As long as the loan does not default, everyone is happy. If the loan defaults, though, problems can arise.
A repurchase agreement, also called a repo, is an agreement between a buyer and a seller in which the seller agrees to buy back the asset at an agreed-upon price at a future time. In most reports, the asset in question is a U.S. government security, so there is virtually no risk on the value of the underlying asset. In essence, a repo is a loan structured as a forward contract. The treasury bond is the collateral. The seller is receiving money and agrees to repay it in the future at a price high enough to compensate the buyer—the lender—for the use of the funds.
Repos are common transactions between banks and large corporations that need to borrow money for short-term purposes, such as meeting payroll, often for as short a time period as overnight.