Trading Vehicles

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Trading Vehicles

All trading vehicles are divided into several classes. Their charts may look similar on a computer screen, but don’t let their looks deceive you. Each group has its pluses and minuses. They offer different profit opportunities and carry different risks. Choosing what to trade is among your most important market decisions.

We’ll review the following major groups to help you make a conscious decision on which to focus:

• Stocks
• ETFs
• Options
• CFDs
• Futures
• Forex

Whichever group you select, make sure your trading vehicle meets two essential criteria: liquidity and volatility.

Liquidity refers to the average daily volume, compared with other vehicles in its group. The higher it is, the easier it’ll be for you to get in and out of your trades. You may build a profitable position in an illiquid stock, only to lose at the exit due to especially bad slippage.

I learned this lesson decades ago, after building a 6,000-share position in a fairly inactive stock. When it began to sag, I decided to sell, and that’s when I discovered that its average daily volume was only 9,000 shares. There were so few people trading it that my own sales began to depress its price. Taking several days to trade out of my 6,000-share lot felt like taking a fat cow through a very narrow gate and leaving large strips of its hide on gate posts. Now I focus on U.S. stocks that trade over a million shares a day. That’s where I can slip in and out of my trades unnoticed and unmolested. With a large number of traders, there are plenty of orders to buy and sell, and my slippage, when it occurs, is small.

Volatility is the extent of average short-term movement of a trading vehicle. The higher the volatility of a trading instrument, the more opportunities it presents. Popular stocks tend to swing a lot. On the other hand, stocks of many utility companies that are quite liquid are very hard to trade because of low volatility—they tend to stay in narrow ranges.

There are several ways to measure volatility, but a good practical tool is “beta.” It compares any vehicle’s volatility to its benchmark, such as a broad index. If a stock’s beta is 1, it means that its volatility is equal to that of the S&P 500. A beta of 2 means that if the S&P rises 5%, the stock is likely to rally 10%, but it is also likely to drop 10% if the S&P falls by 5%. A beta of 0.5 means that the stock is likely to rise or fall by half of the percentage of the S&P. It would be better for a beginner to focus on low beta vehicles. You can find betas for most stocks on all key financial websites, starting with Yahoo Finance. Betas are like trail markers on ski slopes: green for beginners, blue for intermediate skiers, and black diamonds for experts.

Time Zones Globalization has lured many people to trade far away from home. I meet traders in Australia who trade U.S. stocks, and talk with traders in the United States who wrestle with European indexes. Still, you should think twice before trading far away from your own time zone. Your data screen is connected to the world, but your physical self is rooted in the area where you live. If you trade while sleepy, you put yourself at a disadvantage. If your head is on the pillow while your trade is open on the other side of the globe, you make it easier for your competitors to pick your pockets.

Some time zones are easier to trade than others. For example, it is comfortable to trade the U.S. markets from Western Europe, where the New York Stock Exchange opens at 3:30 pm and closes at 10 pm. It is very hard to trade U.S. markets from Asia, where the time difference is likely to be 12 hours. There are always exceptions to a rule, and you may enjoy trading at night—but if you feel tired and sleepy, don’t push yourself but find a local market.

Long or Short There’s more to trading than buying and waiting for prices to rise. Markets are two-way streets: they go down as well as up. Beginners only buy, but experienced traders are comfortable with selling short.

In a nutshell, to make money shorting you identify a vehicle that you expect to drop, borrow it from your broker (giving him a deposit), and sell it. After it declines, you buy it back at a cheaper price, return the borrowed shares to your broker, and get your deposit back. Your profit is the difference between the higher selling and lower buying prices. This is the same as in buying, only the process is reversed: sell first, buy later. Of course, shorting is too complex a topic to cover in two paragraphs, which is why I refer you to my latest book (prior to this one): The New Sell & Sell Short: How to Take Profits, Cut Losses, and Benefit from Price Declines (John Wiley & Sons, 2011).

■ 42. Stocks

A stock is a certificate of ownership of a business. If you buy 100 shares of a company that had issued 100 million shares, you’ll own one-millionth of that firm. If other people want to own that business, they’ll have to bid for your shares.

When masses of people start liking the prospects of a business, their orders for its shares will push up the stock price. If they don’t like the outlook of that business, they’ll start selling their shares, depressing prices. Public companies try to make their shares more attractive in order to push up share prices because it helps them raise more equity or issue debt. Top executives’ bonuses are often tied to stock prices.

Fundamental values, especially earnings, drive prices in the long run, but, as John Maynard Keynes, the famous economist and a canny stock picker once retorted— “In the long run we’re all dead.” Markets are full of cats and dogs, stocks of companies with feeble or nonexistent earnings that at some point fly through the roof, defying gravity. Stocks of new sexy industries can levitate on expectations of future earnings rather than any real profits. Stocks of solidly profitable, well-run companies may drift sideways or down if the crowd isn’t excited about their outlook.

Warren Buffett is fond of saying that buying a stock makes you a partner of a manic-depressive fellow he calls Mr. Market. Each day, Mr. Market runs up to you and offers to buy you out or sell his shares to you. Most of the time, you should ignore him because he’s crazy, but occasionally Mr. Market becomes so depressed that he offers you his shares for a song—and that’s when you should buy. At other times, he becomes so manic that he offers an insane price for your shares—and that’s when you should sell.

Buffett’s idea is brilliant in its simplicity, but hard to implement. Mr. Market’s mood is so contagious that it sweeps most of us off our feet. People want to sell when Mr. Market is depressed and buy when he is manic. To be a successful trader, you must stand apart from the crowd. You need to define objective criteria that will help you decide how high is too high and how low is too low. Buffett makes his decisions on the basis of fundamental analysis and a fantastic gut feel. Traders can use the tools of technical analysis described in this book.

What stocks will you trade? There are more than 20,000 of them in the United States, and even more abroad. Beginners tend to spread themselves too thin. Afraid to miss an opportunity, they buy scanning software. A person who doesn’t have a clear idea of how to trade a single stock will not be helped by tracking thousands. He’ll be much better off focusing on a handful of stocks and following them every day.

We’ll return to the question of stock selection in Part 10 “Practical Details.” In brief, it’s a good idea to limit your pool of trading candidates. That group can be small or large, depending on your skills and available time. A Greek friend of mine calls his watch list of 200 stocks his harem. He’s owned every one of them in the past; he reviews them on weekends, selecting fewer than ten that he may take for a spin in the coming week.

I have two “pools” in which I fish for trading ideas. On weekends, I run the 500 component stocks of the S&P 500 through my divergence scanner and zoom in on stocks flagged by that scan, selecting a handful that I’ll consider trading during the coming week. Second, I review Spike picks on weekends, figuring that among a dozen top traders submitting their favorite picks, there is bound to be at least one that I’ll want to piggyback. The number of stocks I closely monitor during the week is always in single digits. This is just my style; I have friends who monitor several dozen stocks at any given time. Only you can tell what number is right for you, but you should track only as many as you can focus on.

■ 43. ETFs

An exchange-traded fund (ETF) is an investment vehicle that trades like a stock. Different ETFs hold different types of assets, such as stocks, commodities, or bonds, and they usually trade close to their net asset values. There are ETFs designed to track indexes, sectors, countries, commodities, bonds, futures, and forex. The leveraged ETFs are designed to move double or triple the distance of the underlying index. There are also inverse ETFs and leveraged inverse ETFs that trade opposite to their underlying assets: when an index falls, its inverse ETF rises and vice versa. The number of ETFs has reached thousands in recent years.

With so many choices, what’s there not to like about ETFs? Actually, quite a lot.

The industry keeps quiet about the fact that there are two ETF markets. The primary market is reserved for “authorized participants”—large broker-dealers who have agreements with the ETF distributors to buy or sell large blocks, consisting of tens of thousands of ETF shares. These middlemen buy at wholesale and then sell to you at retail. You, as a private trader, always sit in the back of the bus—in the secondary market.

An active trader friend who reviewed this chapter added: “I believe that ‘authorized participants’ can also obtain ETF shares to short in large lots. My broker always tells me there are none available, not even of broadly held ETFs, which I can’t imagine they don’t have lots of in inventory. When I ask them about this, they stonewall. I wonder how such a shorting transaction by an authorized participant is accounted for. I wonder if it somehow ends up as paired transactions (both an up-volume purchase and a down-volume sale, cancelling each other out). If so, the added selling pressure would be hidden from view.”

Administrative expenses incurred by ETFs dampen investors’ returns. According to a study by Morgan Stanley, ETFs missed their 2009 targets by an average of 1.25%, which was double the size of their “miss” in 2008. Those percentages are your “haircuts” for the privilege of trading ETFs rather than individual stocks. The more exotic the index tracked by an ETF, the greater your “haircut.”

Some ETFs lose value so fast that their issuers repeatedly perform reverse splits in order to raise prices back into double digits. With the passage of time, those ETFs sink back into single digits, and then their issuers perform another reverse split to make their ETFs appeal to new suckers.

A friend of mine lost over a million dollars last year: he anticipated a market decline and bought an ETF of a volatility index (volatility rises when markets fall). Sure enough, the market dropped 10% and volatility spiked—but his ETF went down instead of up (Figure 43.1).

Many ETFs “track” their underlying indexes in a shabby manner. After giving commodity ETFs a try, I wouldn’t touch them with a ten-foot pole, having experienced several days during which the underlying commodity went up, while my commodity ETFs went down. I stopped trading country ETFs after running into several situations in which a country index would rise to a new high, while my ETF would stay well below the breakout level (Figure 43.2).

The leveraged ETFs are more “futures-laden” than non-leveraged ETFs and have much greater rollover losses each month. The disadvantages that retail investors suffer are magnified in the leveraged ETFs. They may track their underlying vehicles

FIGURE 43.1 $VIX, the volatility index, and VXX, a volatility ETF, weekly. (Charts by Stockcharts.com)

Tracking Volatility: Reality and Fantasy

Can you believe that these two charts, covering the same period of time, are supposed to track the same thing?

Volatility is a hugely important factor in market movements. Just as prices oscillate between uptrends and downtrends, they oscillate between periods of low and high volatility. This is why many analysts and traders pay close attention to $VIX—the volatility index. The chart on the left shows that during the past two years $VIX oscillated between the low teens and mid-twenties (it briefly rallied above $80 during the 2008 bear market). Traders have a saying: “when VIX is high, it’s safe to buy; when VIX is low, go slow.”

Since $VIX fluctuations appear fairly orderly, some traders attempt to trade it using several ETFs, such as VXX, shown on the right. During the same time, VXX has steadily declined, losing 90% of its value. How’s that for tracking volatility?

FIGURE 43.2 Natural Gas Spot and UNG, a natural gas ETF, monthly. (Charts by Stockcharts.com)

Natural Gas Market: Reality and Fantasy

The chart on the left shows prices of the natural gas spot market: it topped out near $13.5 in 2008 and began a bear market that ended with a double bottom. A false downside breakout near $2 in 2012 helped identify a buying opportunity. A futures chart (not shown) looks very similar to the spot chart—but take a look at UNG, the natural gas ETF on the right. As it slid interminably from above $500 to below $20, I lost count of the number of friends and clients who complained of losing money trying to pick its bottom.

more or less correctly during a single trading session, but deviate widely with the passage of time.

The only ETFs that trade more or less decently are broadly based ones, such as SPY and QQQ. Overall, ETFs attract many unsophisticated retail clients, but the pervasive haircuts and poor tracking of the underlying securities slant the field against them. Remember an important principle: TANSTAFL—“there ain’t no such thing as a free lunch.” When it comes to ETFs: buyer beware.

■ 44. Options

An option is a derivative instrument—a bet that another security, such as a stock, an index, or a future will reach a certain price by a certain date. A call gives its holder a right, but not an obligation, to buy a certain quantity of a specified security at a specified price at a specified time. It is a bet on a price increase. A put is a right, but not an obligation, to sell a certain quantity of a specified security at a specified price at a specified time. It is a bet on a price drop. There are two parties in every options trade: a buyer and a seller, also called a writer. Buyers buy options, while writers create options and sell them to buyers.

The key point to keep in mind is that option buyers as a group lose money over time, despite occasional lucky trades. At the other end of the table, options writers as a group make steady money despite occasional losses.

Writers create options out of thin air to meet demand from option buyers. One of my students, a market-maker on the floor of the American Stock Exchange, said to me: “Options are a hope business. You can buy hope or sell hope. I am a professional— I sell hope. I come to the floor in the morning and find what the public hopes for. Then I price that hope and sell it to them.”

Each option has an exercise price (also called strike price). If a stock fails to reach that price before the exercise date, the option expires worthless and the buyer loses what he paid, while the writer keeps his loot, whose polite name is premium.

• An option is at-the-money when the current price of the underlying security equals the exercise price.
• A call is out-of-the-money when the current price of the underlying security is below the exercise price. A put is out-of-the-money when the current price of the underlying is above the exercise price. The farther out-of-the-money, the cheaper the option.
• A call is in-the-money when the current price of the underlying security is above the exercise price. A put is in-the-money when the current price of the underlying is below the exercise price.

An option can be at-the-money, out-of-the-money, or in-the-money at different times in its life, as the price of the underlying security fluctuates. The price of every option has two components—an intrinsic value and a time value.

• An option’s intrinsic value rises above zero only when it’s in-the-money. If the exercise price of a call is $80 and the underlying security rises to $83, the intrinsic value of your call will be $3. If the security is at or below $80, the intrinsic value of that call is zero.
• The other component of an option’s price is time value. If the stock trades at $74 and people pay $2 for an $80 call, the entire $2 represents time value. If the stock rises to $83, and the price of the call jumps to $4, $3 of that is intrinsic value ($83 – $80), while $1 is time value (the hope that this stock will rise even higher during the remaining life of that option).

Option prices depend on several factors:

• The farther out-of-the-money the exercise price, the cheaper the option—the underlying security must travel a longer distance to make the option worth anything before it expires.
• The closer the expiration day, the cheaper the option—it has less time to fulfill the hope. The speed with which an option loses value is called “time decay,” which doesn’t occur in a straight line but becomes steeper as the expiration nears.
• The less volatile the underlying security, the cheaper the option, because it has a smaller chance of making a large move.
• Minor factors influencing option prices include the current level of interest rates and the dividend rate of the underlying stock.

Different factors that impact option pricing may clash and partly cancel each other out. For example, if a market drops sharply, reducing the value of calls, the increased volatility will lift option values, and the calls may lose less than expected. There are several mathematical models, such as Black-Scholes, widely described in options literature, that are used to determine what is called a fair value of any option.

Buying Options

The simplest and easiest approach to options is to buy them. That’s exactly what beginners do, and unless they learn quickly and change, their accounts are doomed.

This is the standard line of brokerage house propaganda: “Options offer leverage—an ability to control large positions with a small outlay of cash. The entire risk of an option is limited to the price you pay for it. Options allow traders to make money fast when they’re right, but if the market reverses, you can walk away and owe nothing!” They fail to mention that in order to profit from buying an option you must be right in three ways. You must choose the right stock, predict the extent of its move, and forecast how fast it’ll get there. If you’re wrong on even one of these three choices, you’ll lose money.

Ever tried tossing a ball through three rings at an amusement park? This triple complexity makes buying options a losing game.

A stock, an index, or a future can do one of three things: rise, fall, or stay flat. When you buy a call, you can profit only if the market rises; you lose if it goes down or stays flat. You can lose even if it rises, but not fast enough. When you buy a put, you win only if the market falls fast enough. An option buyer makes money only if the market goes his way at a good enough speed, but loses if it moves his way slowly, stays flat, or goes against him.

An option buyer has one chance out of three to win—but the odds are two out of three in favor of an option writer. No wonder the pros write options. A pro sells a call, and if a stock drops, stays flat, or even rises slowly, that call will expire worthless, and he’ll keep the premium. He sells poor buyers hope—and as that hope turns out to be worthless, he keeps their money.

Options attract hordes of small traders who can’t afford to buy stocks. To get a bigger bang for their buck, they buy calls as if those were substitutes for stocks. This doesn’t work because options move differently from stocks. Gullible amateurs buy empty hopes, which the pros are delighted to sell to them.

Beginners, gamblers, and undercapitalized traders make up the majority of option buyers. Just think of all the money those hapless folks lose in their eagerness to get rich quick. Who gets all that money? Some of it goes for brokerage commissions, but the bulk flows into the pockets of option writers. Well-capitalized professionals write options rather than buy them. Option writing is a capital-intensive business: you need hundreds of thousands of dollars at a minimum to do it right, and most successful writers operate with millions. Writing options is a serious game for knowledgeable, disciplined, and well-capitalized traders. If your account is too small for option writing, wait until it grows bigger.

Markets are like pumps that suck money out of pockets of the poorly informed majority and into the wallets of a savvy minority. Smart traders in any market look for situations in which the majority does something one way, while a small, moneyed minority does the opposite. Options are a great example of this rule.

Writing Options

There are two main types of option writing. Covered writers buy a stock and write options against it. Naked writers write calls and puts on stocks they don’t own.

Covered writers own underlying securities. For example, a fund may hold a large position in IBM stock and sell calls against it. If the stock doesn’t rise to the exercise price during the life of those calls, the options will expire worthless. The covered writer will add his premium to the fund and write a new call with a new expiration date. If IBM does rise to the exercise price and “gets called,” they’ll deliver their stock at its strike price, collect the money, and use the freed-up capital to buy another stock and write calls against it.

Large funds tend to use computerized models for buying stocks and writing covered calls. Covered writing is a mathematically demanding, capital-intensive business. Most serious players spread their costs, including staff and equipment, across a large capital base. A small trader doesn’t have much of an edge in this expensive enterprise. Covered writing was very profitable in the early years of exchange-traded options. By now the field is very crowded, and the returns have become thinner.

Naked writers sell options without owning their underlying securities; they back up their writes with cash in their accounts. A naked writer collects his premium when he opens a trade, but his risk is unlimited if that position goes against him. If you own a stock, sell a covered call, and that stock rises to its exercise price and gets called, you have something to deliver. If you sell a naked call and the stock rises to or above its exercise price, you’ll have to pay. Imagine selling calls on a stock that becomes a takeover play and opens $50 higher the next morning—you still have to deliver.

This combination of limited rewards with unlimited risks scares most traders away from naked writing—but as usual, there’s a gap between perception and reality. A far-out-of-the-money option with a short time to the expiration is very likely to expire worthless, meaning the writer will profit. The risk/reward ratio in naked writing is better than it looks, and there are techniques for reducing the impact of a rare adverse move.

Savvy naked writers tend to sell out-of-the-money calls and puts whose underlying stocks or futures are unlikely to reach their strike prices during the remaining life of an option. They sell not just hopes but distant hopes. Good writers track volatility to find how far a stock is likely to move and then sell options outside of that range. This game goes into high gear during the week or two prior to option expiration, when the floor mints money out of thin air, selling naked puts and calls that have almost no chance of reaching their exercise price.

Cautious writers close their positions without waiting for the expiration dates. If you write a call at 90 cents and it goes down to 10 cents, it makes sense to buy it 182 TRADING VEHICLES

back and unwind your position. You’ve already earned the bulk of potential profit, so why expose yourself to continued risk? It’s cheaper to pay another commission, book your profits, and look for another writing opportunity.

Becoming a naked writer requires iron discipline. The size of your writes and the number of positions must be strictly determined by your money management rules. If you sell a naked call and the stock rallies above its exercise price, it exposes you to the risk of ruin. You must decide in advance at what level you will cut and run, taking a relatively small loss. A naked seller cannot afford to sit and hope when a stock moves against him.

Writer’s Choice

Time is the enemy of options buyers. Every buyer has lived through this sad sequence: they buy a call, the stock rises, but their option fades to zero, and they lose money. Buyers lose when the underlying security takes longer than expected to get to the level at which they can collect on their bet. Most options become worthless by their expiration date.

What if we reverse this process and write rather than buy options? The first time you write an option, and do it correctly, you’ll experience the delicious sensation of time working in your favor. The option that you wrote loses some of its time value each day, making the premium you’ve collected safer. When the market goes nowhere, you still make money, as time value keeps evaporating, making it more likely that you’ll keep the premium.

If living well is the best revenge, then taking a factor that kills most options buyers—time—and making it work for you is a gratifying experience.

Since each option represents a hope, it’s better to sell empty hopes which are unlikely to be fulfilled. Take three steps before writing a call or a put:

1. Analyze the security against which you want to write options.

Use Triple Screen to decide whether a stock, future, or an index is trending or non-trending. Use weekly and daily charts, trend-following indicators, and oscillators to identify trends, detect reversals, and set up price targets. Avoid writing when earnings are about to be announced—do not hold open positions during those potentially stormy days.

2. Select the type of option to write.

If your analysis is bearish, consider writing calls, but if bullish, consider writing puts. When the trend is up, sell the hope that it will turn down, and when it’s down, sell the hope it’ll turn up. Do not write options when markets are flat and premiums low—a breakout from a trading range can hurt you.

3. Estimate how far, with a generous safety margin, the stock would have to run in order to change its trend. Write an option beyond that level.

Write an option with a strike price the market is unlikely to reach before the option expiration. An objective tool that shows the degree of safety of your planned position is an indicator called Delta, which we’ll discuss below.

Time Decay Options lose value with each passing day, but their rate of decay isn’t steady. Options drop faster as the expiration date draws closer. Like a boulder rolling downhill, time decay becomes vertical at the final cliff.

Time decay is bad for option buyers, but very good for option writers. You collect your premium the day you sell a call. The deeper it falls below the price at which you wrote it, the safer your premium. Time decay is a friend of the option writer but an enemy of the option buyer.

With that in mind, the sweet spot for an option writer is approximately two to three months from option expiration. That’s when time decay starts gathering speed. It accelerates in the last few weeks of the option’s life. When you write options close to the expiration, you benefit from faster time decay. You can get more money for options with longer lives, but don’t be greedy. The goal of a writer is not to make a killing on any single trade but to grind out steady income.

Delta is a tool that shows the probability of the underlying security reaching your option’s exercise price by its expiration date. It’s one of several options tools, collectively called the “Greeks” (each is named after a letter of the Greek alphabet). You can find Delta for any stock, index, or ETF on many financial websites, especially those of brokerages that offer options services.

A cautious option writer should aim to sell calls or puts whose Delta isn’t much above 0.10, meaning there is only a 10% chance of the exercise price getting hit before the expiration date. Remember, as an option writer you don’t want the underlying security to reach that price: you want to sell empty hopes. If 10% risk seems high, keep in mind that Delta is derived without any reference to market analysis. If your decision is based on good technical analysis, your risk will be lower than what Delta indicates.

The temptation to sell naked options closer to the money and get fatter premiums is dangerous. The Delta is likely to be high, meaning that a slight counter-trend move can push your position underwater. If you’re going to write options, treat it like writing accident insurance policies. To make steady profits and sleep well at night, sell your auto insurance policies to ladies who only drive to supermarkets rather than to motorcycle daredevils.

Limiting Risk

A big options trader shared with me his technique of “slicing the bid-ask spread.” He puts in a low bid or a high ask and then starts giving up a penny at a time until somebody bites. For example, he recently saw an option he wanted to write (i.e., sell). The bid was $1.18 and the ask $1.30, but he had no intention of selling at $1.18 and paying that huge spread. Instead, he put in his order to sell a large number of contracts at $1.29, a penny cheaper than the ask. No response. A few minutes later he lowered his ask to $1.28—and suddenly a buyer materialized, snapped up his contracts, and then the bid-ask spread went back to $1.18/$1.30. My client finds there are large traders watching from the sidelines, not showing their hand, but willing to trade within the spread. He gets them to bite by giving up a penny at a time.

Option writers can get hurt in one of three ways. Some overtrade, creating positions that are too large for their accounts. Assuming too much risk makes them nervous and unable to hold positions through any wiggles. Option writers also get hurt when they fail to run fast enough when an option moves against them. Finally, option writers can get blown out if they don’t have a reserve against a major adverse move. The longer you trade, the greater the risk of a catastrophic event.

A writer can grow careless selling naked options and pocketing profits. A smug feeling of self-satisfaction can blind him to reality. You must protect all trades, including naked options. Several suggestions:

■ Set your profit-taking zone—consider buying back your naked options.

The option you write is a wasting asset. When the underlying security moves far from the exercise price but there is still time left to the expiration, the price of the option you sold may fall near its rock bottom and lose value in tiny dribs and drabs. The loser who bought that option still has a bit of a chance that the market may reverse in his favor. He continues to hold that option like a lottery ticket and once in a rare while his ticket may win.

As a writer, why hold an open position that has already given you most of its potential profit? You have little to gain, while remaining exposed to risk. After the option you sold loses half of its value, consider buying it back to close your profitable trade. By the time an option loses 80% of its value, you should be out of that trade.

■ Use a mental stop-loss on the option you sold.

It is better to use mental stops here because many pros go fishing for stops of thinly traded options. Using mental stops requires iron discipline—another reason why option writing isn’t a beginners’ game.

Set your mental stops both on the underlying security and the option itself. For example, you may sell a naked April 80 call on a stock trading at 70 and place your mental stop at 75. Get out of your naked option position before it gets into the money. Also, set a stop on your option: if it doubles in price, buy it back to cut the loss. If you sold an option for $1.50, buy it back if it rises to $3. It may hurt, but it’ll be nowhere near the “unlimited loss” that makes people afraid to write options.

■ Open an insurance account.

You may write a put and the market crashes the next day, or you write a call and suddenly there is a takeover. You hope this never happens—but trade long enough and eventually everything will happen! That’s why you need insurance. Nobody will write it for you, so you’ll have to self-insure.

Open a money market account, and every time you close out a profitable naked writing position, throw 10 percent of your profit into that account. Do not use it for trading—let your insurance account grow with each new profit, ready to cover a catastrophic loss or to be taken out in cash when you stop writing options. In a recent consultation with a professional option writer, I recommended that he send 10% of his profit above a certain threshold to the bank that holds the mortgage on his country house, using that prepayment as his insurance fund.

Can Option Buying Be Intelligent?

Professionals may buy puts on a rare occasion when they expect a severe drop. When a long-term uptrend begins to turn, it can create massive turbulence near the top, similar to an ocean liner changing its course. When volatility goes through the roof, even well-heeled traders have trouble setting stops on shorts. Buying puts allows you to sidestep this problem.

Prices tend to fall twice as fast as they rise. Greed, the dominant emotion of uptrends, is a happy and lasting feeling. Fear, the dominant emotion of downtrends, is sharper and more violent. Professionals are more likely to buy puts because of shorter exposure to time decay. Uptrends are better traded with stocks or futures.

A trader who expects a downswing must decide what put to buy. The best choice is counterintuitive and quite different from what most people get.

• Estimate how low you expect a stock to collapse. A put is worth buying only if you expect a crash.
• Avoid puts with more than two months of life. Buying puts makes sense only when you expect a waterfall decline. If you anticipate a drawn-out downtrend, better sell short the underlying security.
• Look for cheap puts whose price reflects no hope. Move your finger down the column: the lower the strike, the cheaper the put. At first, each time you drop to the next strike price, a put is 25% or even 35% cheaper than at the previous level. Eventually you come to the strike level at which you would save only a tiny fraction of a put’s price. This shows that all hope has been squeezed out of that put, and it is priced like a cheap lottery ticket. That’s the one you want!

Buying a very cheap, far-out-of-the-money put is counterintuitive. It is so far out of the money and has so little life left in it that it’s likely to expire worthless. You can’t place a stop on it, and if you’re wrong, the entire premium will go up in smoke. Why not buy a put closer to the money?

The only time to buy a put is when you’re shooting for an exceptional gain from a major reversal. In an ordinary downtrend it’s better to short stocks. With cheap farout-of-the-money puts you aim for a tenfold gain or better. Returns like these allow you to be wrong on a string of such trades, yet come out ahead in the end. Catching one major reversal will make up for several losses and leave you very profitable.

Why don’t more people use this tactic? First, it requires a great deal of patience, as opportunities are very infrequent. The entertainment value is very low. Most people can’t stomach the idea of being wrong three, four, or five times in a row, even if they are likely to make money in the end. That’s why so few traders play this game.

I wrote this chapter to sharpen your focus on some of the key options ideas. If interested in options, study Lawrence MacMillan’s book Options as a Strategic Investment. 186 TRADING VEHICLES

■ 45. CFDs

A contract for difference (CFD) is a bet on the future value of a currency, an index, or a stock. If you buy a CFD and the price of the underlying vehicle rises, you’ll collect the difference from the company that sold you the contract, but if it falls, you’ll pay the difference. CFDs are derivatives that allow speculators to bet on rallies or declines. They are similar to spread betting, which is legal in the United Kingdom and Ireland, but not in the United States.

At the time of this writing, CFDs are available in Australia, Canada, France, Germany, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Poland, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. They are prohibited in the United States, due to restrictions by the Securities and Exchange Commission.

CFDs were invented in the early 1990s by Brian Keelan and Jon Wood, both of UBS Warburg in London. Institutional traders began using them to hedge stock exposure and to avoid taxes. In the late 1990s, several firms began marketing CFDs to retail traders, touting their leverage and the exemption from UK taxes. Several provider firms expanded their offerings from the London Stock Exchange to global stocks, commodities, bonds, and currencies. Index CFDs, based on the major global indexes such as Dow Jones, S&P 500, FTSE, and DAX, quickly became the most popular vehicles of the group.

CFDs are contracts between individual traders and providers, who may offer different deal terms. Each CFD is created by opening a trade with a provider, based on some underlying instrument. Be prepared to pay large bid-ask spreads, commissions, and overnight financing. Trades are mostly short-term, although positions can be taken overnight. Financing charges and profits or losses are credited or debited daily. CFDs are traded on margin.

Among the pluses of CFDs are the tiny minimum sizes of those contracts, making them accessible to small traders. The absence of the expiration dates means there is no time decay. While financing is charged on long positions, it is paid out on short positions.

There are several serious misgivings about the CFDs. Commissions tend to be high relative to contract sizes. Bid-ask spreads are controlled by CFD issuers, who also control prices of contracts, which may deviate from prices of the underlying securities. In other words, a retail customer plays against a professional team that can move the goal posts during the game.

A client from New Zealand wrote: “Regarding CFDs and spread betting, it is worth understanding that with CFDs you are not just trying to beat the market but the casino too. CFD providers can set whatever prices they like for an instrument, as it is their instrument. The fact that sometimes it emulates what happens in the stock market does not mean it is the same as trading in the stock market.”

CFDs are heavily marketed to new and inexperienced traders, extolling their potential gains, while glossing over risks. The Australian financial regulator ASIC considers trading CFDs riskier than gambling on horses or in casinos. CFDs are banned in the United States where regulators haven’t forgotten the bucket shops that flourished at the turn of the twentieth century.

The stance of the SEC in this matter reminds me of another federal agency, the Food and Drug Administration, which kept Thalidomide, a drug for pregnant women, out of the United States. As a result, after the full scale of its horrible side effects became known, the U.S. population was spared an epidemic of deformed babies that was caused by that drug in Europe.

■ 46. Futures

A future is a contract for delivery of a specific quantity of a commodity by a certain date at an agreed-upon price. Futures contracts differ from options by being binding on both the buyer and the seller. In options, the buyer has the right but not an obligation to take delivery. If you buy a call or a put, you can walk away if you like, but in futures, you have no such luxury. If the market goes against you, you have to get out of your trade at a loss or add to your margin. Futures are stricter than options, but their responses to market volatility are much smoother, making them easier to trade. Another advantage of futures is that there are only a few dozen of them, making them easier to track. Futures are not nearly as correlated with each other as stocks. While stocks tend to move as a group, many futures move in unrelated trends, offering more trading choices.

Commodities are the irreducible building blocks of the economy. Wheat is a commodity, while bread isn’t because it includes multiple components. Old-timers used to joke that a commodity was something that hurt when you dropped it on your foot gold, sugar, wheat, a barrel full of crude oil. In recent decades, many financial instruments began to trade like commodities—stock indexes, bonds, and currencies. Futures include financial instruments along with traditional commodities.

The person who buys a stock becomes a part owner of a company, but when you buy a futures contract, you don’t own anything. You enter into a binding contract for a future purchase of merchandise, be it a carload of wheat or a sheaf of Treasury bonds. The person who sells you that contract assumes the obligation to deliver. The money you pay for a stock goes to the seller, but in futures your margin money stays at the clearinghouse as a security, to ensure you’ll accept delivery when your contract comes due. That’s why they used to call margins “honest money.” While in stocks you pay interest for margin borrowing, in futures you can collect interest on your margin funds.

Each futures contract has a definite size and a settlement date. Most traders close out their contracts early, settling profits and losses in cash. Still, the existence of a delivery date forces people to act, providing a reality check. A person may sit on a losing stock for years, deluding himself that it’s only a paper loss. In futures, reality, in the form of the settlement date, always intrudes on a daydreamer.

Most futures have daily limits beyond which prices are not allowed to go. Limits are designed to interrupt hysterical moves and give people time to rethink their positions. A string of limit days can be very stressful when a losing trader is stuck and unable to get out while his account is being ground down. The globalization of the futures markets has created many emergency exits, allowing you to unwind a trade elsewhere. Just like when boarding a plane, a careful trader learns to identify those emergency exits before he needs them.

In stocks, most people buy and very few sell short. In futures, just like in options, the size of long and short positions is always equal because if someone buys a contract for future delivery, someone else has to sell it to him, i.e., go short. If you want to trade futures, it pays to be comfortable shorting.

The survival rate for new futures traders is low—nine out of ten newcomers are said to bust out in the first few months. It is important to understand that the danger is not in futures but in a gross lack of risk-management skills among beginners. Futures offer some of the best profit opportunities to serious traders but are deadly for amateurs. You must develop excellent money-management skills (described in Chapters 49–51) before venturing into futures.

Futures and Cash Trades

To compare a futures trade with a cash trade, let’s assume the following: it is February, gold is trading at $1,500 an ounce, and your analysis indicates that it’s likely to rise to $1,575 within weeks. With $150,000, you can buy a 100-oz gold bar from a dealer and store it in a safe. If your analysis is correct, in a few weeks your gold will be worth $157,500. You can sell it and take $7,500 profit, or 5% before commissions—nice. Now let’s see what happens if you trade futures based on the same analysis.

Since it is February, April is the next delivery month for gold. One futures contract covers 100 oz of gold, with a value of $150,000. The margin to trade this contract is only $7,500. In other words, you can control $150,000 worth of gold with a $7,500 deposit. If your analysis is correct and gold rallies $75 per ounce, you’ll make roughly the same profit as when you bought 100 oz of gold for cash; only now your return will be 100% on your investment instead of 5%, since your margin is only $7,500.

Many people, after seeing such numbers, feel a surge of greed and buy multiple contracts. A trader with $150,000 in his account has enough margin for 20 contracts. If he can double his money on a single contract, he can double it on 20. If he repeats it two or three times, he’ll quickly become a millionaire.

Wonderful—but there is a catch.

Markets seldom move in a straight line. Your analysis may well be correct, and gold may rise from $1,500 to $1,575 within a few weeks, but it’s perfectly possible that it may dip to $1,450 along the way. That $50 dip would create a $5,000 paper loss if you bought 100 oz of gold for cash—unpleasant but not a tragedy. For a futures trader who bought multiple contracts, each on a $7,500 margin, that $50 decline would mean a wipeout. His broker would call demanding more margin, and if he has no reserves, the broker will sell him out at a loss.

Inexperienced traders keep buying too many contracts and keep getting kicked out by the first wiggle of their market. Their analysis may be correct—gold may rise to its target price—but the beginner is doomed because he commits too much of his equity and has very thin reserves. Futures don’t kill traders—poor money management kills futures traders.

Futures can be very attractive for traders with strong money-management skills. High rates of return demand ice-cold discipline. A beginner is better off with slowermoving stocks. Once you’ve matured as a trader, you can take a closer look at futures. Also, read some introductory books. Winning in the Futures Market by George Angell is a good primer, to be followed by The Futures Game by Teweles and Jones.

Hedging

Futures markets serve an important economic function: they permit commercial producers and consumers to hedge commodity price risks, giving them a competitive advantage. At the same time, futures offer speculators a gambling palace with more choices than any casino.

Hedging means opening a futures position opposite to one’s position in the actual commodity. For example, a major candy manufacturer knows months in advance how much sugar the firm is going to need. He buys a corresponding number of sugar futures in New York or London when prices are good enough for the firm. They’ll be needing trainloads of sugar several months from now, but meanwhile they hold sugar futures, which they plan to sell when they buy their cargoes.

If sugar prices go up and they have to pay more for the raw commodity, they will offset that loss by making roughly the same profit on their futures position. If sugar prices fall, they’ll lose money on their futures contracts but make it up in savings on the raw materials. Their unhedged competitors are taking chances. If sugar prices fall, they’ll buy on the cheap and reap a windfall, but if prices rise, they’ll be hung out to dry. Hedged consumers can concentrate on running their core businesses, insulated from future price swings. Airlines know years in advance how much jet fuel they’ll need, and buying oil futures protects them from price spikes that often occur in this volatile market.

Producers of commodities also benefit from hedging. An agribusiness can presell its wheat, coffee, or cotton when prices are high enough to assure profits. They sell short enough futures contracts to cover the size of their prospective crop. From that point on, they have no price risk. If prices go down, they’ll make up their losses on cash commodity by profits on short futures trades. If prices go up, they’ll lose money on their short futures positions but make it back selling the actual commodity at higher prices.

Hedging removes price risk from planning to buy or to deliver a cash commodity. It allows commercial interests to concentrate on their core businesses, offer stable consumer pricing, and obtain a long-term competitive advantage.

Hedgers give up a chance of a windfall but insulate themselves from price risks. Survivors value stability. That why the Exxons, the Coca-Colas, and the Nabiscos of the world are among the major players in commodity markets. Hedgers are the ultimate insiders, and a good hedging department not only buys price insurance, but also serves as a profit center.

Hedgers transfer price risks to speculators who enter the markets, lured by the glitter of potential profits. It’s ironic that hedgers, who have inside information, are not fully confident about prices, while crowds of cheerful outsiders plunk down money to bet on futures.

The two largest groups of speculators are farmers and engineers. Farmers produce commodities, while engineers love to apply scientific methods to the futures game. Many farmers enter futures markets as hedgers but catch the bug and start speculating. It never ceases to amaze me how many farmers end up trading stock index futures. As long as they trade corn, cattle, or soybeans, their feel for the fundamentals gives them an edge over city slickers. But what’s their edge in the S&P500?

Supply, Demand, and Seasonality

Major bull and bear markets in futures are driven by supply or demand. Supplydriven markets tend to be fast and furious, while demand-driven markets tend to be quiet and slow. Why? Think of any commodity, say coffee, which grows in Africa and South America.

Changes in demand come slowly, thanks to the conservatism of human nature. The demand for coffee can increase only if drinking becomes more popular, with an espresso machine in every bar. The demand can fall off if coffee drinking becomes less popular, due to a deteriorating economy or in response to a health fad. Demanddriven markets move at a leisurely pace.

Now imagine that a major coffee growing area is hit by a hurricane or a freeze. Suddenly the world supply of coffee is rumored to be reduced by 10% and prices shoot up, cutting off marginal consumers. Imagine a new OPEC policy sharply curtailing crude oil supply or a general strike in a leading copper-mining country. When a commodity’s supply is reduced or even rumored to be reduced, its price climbs, reallocating tight supplies to those best able to afford them.

Grain prices often spike during spring and summer planting and growing seasons, as dry spells, floods, and pests threaten supplies. Traders say that a farmer loses his crop three times before harvesting it. Once the harvest is in and the supply is known, demand becomes the driving force. Demand-driven markets have narrower channels, with smaller profit targets, and lower risks. As seasons change, channels have to be redrawn, and trading tactics adjusted. A new trader may wonder why his tools stopped working. A smart trader gets out a new set of tools for the season and puts old ones in storage until next year—just as he swaps regular and snow tires on his car.

A futures trader must know the key supply and demand factors of the market he’s trading. For example, he must keep an eye on the weather during the critical growing and harvesting months in agricultural commodities. Trend traders in the futures markets tend to look for supply-driven markets, while swing traders can do just as well in demand-driven markets.

Most commodities fluctuate through the seasons. Freezing spells in the United States are bullish for heating oil futures. Orange juice futures used to have wild runups during the frost season in Florida, but have become much more sedate due to the increase of orange production in Brazil in the Southern hemisphere. Seasonal trades take advantage of such swings, but you have to be careful because those cycles are seldom identical. Be sure to put your seasonal trades through the filter of technical analysis.

Floors and Ceilings

Commodities, unlike stocks, rarely trade below certain price floors or above price ceilings. The floor depends on the cost of production. When the price of a commodity, be it gold or sugar, falls below that level, miners stop digging and farmers stop planting. Some third-world governments, desperate for dollars and trying to avoid social unrest, may subsidize production, paying locals in a worthless local currency and dumping their product on the world market. Still, if enough producers close up and quit, the supply will shrink, and prices will have to rise to draw in new suppliers. If you look at a 20-year chart of most commodities, you’ll see that the same price areas have served as a floor year after year.

The ceiling depends on the cost of substitution. If the price of a commodity rises, major industrial consumers will start switching away from it. If soybean meal, a major animal feed, becomes too expensive, the demand will switch to fishmeal, and if sugar becomes too costly, the demand will switch to corn sweeteners.

Why don’t more people trade against those levels? Why don’t they buy near the floor and short near the ceiling, profiting from what is similar to shooting fish in a barrel? First of all, neither the floor nor the ceiling is set in stone, and markets may briefly violate them. Even more importantly, the human nature works against those trades. Most speculators don’t have the courage to short a market that’s boiling near record highs or go long a market after it has crashed.

Contango, Inversion, and Spreads

All futures markets offer several contracts for different delivery months. For example, you can buy or sell wheat for delivery in September or December of this year, March of next year, and so on. Normally, the nearby months are cheaper than the remote ones, and that relationship is called a contango market.

Higher prices for more remote deliveries reflect the “cost of carry”—financing, storing, and insuring a commodity. The differences between delivery months are called premiums, and hedgers closely watch them. When supply tightens or demand increases, people start paying up for the nearby months, and the premium for the faraway months begins to shrink. Sometimes the front months become more expensive than faraway months—the market becomes inverted! There is a real shortage out there, and people are paying extra to get their stuff sooner. This so-called “inversion” is one of the strongest signs of a bull market in a commodity.

When you look for inversions, keep in mind that there is one market in which inversion is the norm. Interest rate futures are always inverted because those who hold cash positions keep collecting interest instead of paying finance and storage charges.

Professionals don’t wait for inversions—they monitor the narrowing or widening of premiums. A good speculator can rattle off the latest prices, but a floor trader will quote you the latest premiums. A savvy trader knows by heart the normal spreads between different delivery months.

Hedgers tend to dominate the short side of the markets, most speculators are perpetual bulls, but floor traders love to trade spreads. Spreading means buying one delivery month and selling another in the same market. It also means going long one market while shorting a related one.

If the price of corn, a major animal feed, starts to rise faster than the price of wheat, at some point ranchers will start using wheat rather than corn. They’ll reduce their purchases of corn, while buying more wheat, pushing their spread back towards the norm. Spread traders bet against deviations and for a return to normalcy. In this situation, a spreader will short corn and buy wheat, instead of taking a directional trade in either market.

Spread trading is safer than directional trading and has lower margin requirements. Amateurs do not understand spreads and have little interest in these reliable but slow-moving trades. There is not a single book on spreads I can recommend, a sign of how well professionals have sown up this area of knowledge and kept the outsiders out. This is one of a handful of niches in the markets where professionals are earning high incomes without the benefit of a single good how-to book.

Commitments of Traders

Brokers report their clients’ positions to the Commodity Futures Trading Commission (CFTC), which strips away personal data and releases summaries to the public. Their Commitments of Traders (COT) reports are among the best sources of information on what the smart money is doing in the futures markets.

COT reports reveal positions of three groups—hedgers, big traders, and small traders. Hedgers identify themselves to brokers because that entitles them to several advantages, such as lower margin deposits. Big traders are those who hold the number of contracts above the “reporting requirements,” set by the government. Whoever is not a hedger or a big trader is a small trader.

In the old days, big traders used to be the smart money. Today, the markets are bigger, the reporting requirements much higher, and big traders are likely to be commodity funds, most of them not smarter than run of the mill traders. The hedgers are today’s smart money, but understanding their positions isn’t as easy as it seems.

For example, a COT report may show that in a certain market, hedgers hold 70% of shorts. A beginner who thinks this is bearish may be completely off the mark if he doesn’t know that normally hedgers hold 90% of shorts in that market, making the 70% stance wildly bullish. Savvy COT analysts compare current positions to historical norms and look for situations where hedgers, or the smart money, and small traders, many of whom are gamblers, are dead set against each other. If you find that in a certain market the smart money is overwhelmingly on one side, while the small specs are mobbing the other, it is time to use technical analysis to look for entries on the side of hedgers.

Margins and Risk Control

Futures’ low margin requirements make them more rewarding than stocks but also much more dangerous. When buying stocks in the United States, you must put up at least half of their cash value with the broker giving you a margin loan for the rest. If you have $40,000 in your account, you may buy $80,000 worth of stocks, and no more. This margin limit was implemented after the Crash of 1929 when it became clear that low margins led to excessive speculation, which contributed to the viciousness of declines. Prior to 1929, speculators could buy stocks on a 10% margin, which worked great in bull markets but forced them to liquidate when prices slid, pushing the market lower during bear markets.

Margins of only three to five percent are common in the futures markets, allowing traders to make huge bets with little money. With $40,000 in your account, you may control about a million dollars’ worth of merchandise, be it pork bellies or stock index futures.

For example, if gold trades at $1,500/oz and you buy a 100-oz contract on a $7,500 margin and catch a $75 price move, you’ll gain 100%. A beginner looks at these numbers and exclaims, “where have I been all my life?” He thinks he’s found a royal road to riches. But there is a catch. Before that market rises $75, it may dip $50. That meaningless blip will trigger a margin call and force a small speculator’s account to go bust—despite his correct forecast.

Easy margins attract adrenaline junkies who quickly go up in smoke. Futures are very tradable—but only if you follow strict money management rules and don’t go crazy with easy margins. Professionals put on small initial positions and pyramid them if a trade moves in their favor. They keep adding new contracts while moving stops beyond breakeven.

When you become interested in futures, it’s a good idea to make your first steps in those markets where you know something about the fundamentals. If you are a cattle rancher, a house builder, or a loan officer, then cattle, lumber, or interest rate futures would be logical starting points. If you have no particular interests, make your first steps in relatively inexpensive markets. In the United States, corn, sugar, and, in a slow year, copper can be good markets for beginners. They are liquid, volatile, and not too expensive.

We’ll return to the futures markets in Part 9, “Risk Management.” There you’ll find which contracts you may or may not trade, depending on their price and volatility as well as your account size.

Futures traders with small accounts sometimes trade mini-contracts. For example, a regular contract of gold represents 100 oz of the yellow metal, but a minicontract covers only 20 oz. Mini-contracts trade during the same hours as regular contracts and closely track their prices. Their commissions are similar to those for regular contracts, taking a proportionately bigger bite from each trade. Their slippage tends to be bigger due to lower volumes. The exceptions are stock index futures, where mini contracts have higher volumes than regular ones.

■ 47. Forex

The currency market is the largest asset class in the world by trading volume, with a turnover of over $4 trillion per day. Currencies trade around the clock—from 20:15 GMT on Sunday to 22 GMT on Friday, stopping only on weekends. While some currency trades serve the hedging needs of importers and exporters, most transactions are speculative.

The United States is the only country in the world where most people don’t think much about currencies. The moment an American sets foot abroad, he realizes that everyone, from executives to taxi drivers, watches the exchange rates. When people outside the United States get their hands on a bit of trading capital, often their first idea is to trade forex.

The forex market has no central location. Institutions deal in the interbank market, trading with each other using online platforms, such as Bloomberg or Reuters. Unless you can trade $10 million of spot forex at a pop, you’ll be trading retail, going through a broker.

Most beginners open accounts at forex shops where they immediately run into a fatal flaw—your broker is your enemy. When you trade stocks, futures, or options, your broker is your agent: he executes your trades for a fee, and that’s the end of it. Not so in most forex (as well as CFD) houses, where your broker is likely to take the opposite side of every trade. You and the forex house are now against each other: if you lose, your broker will profit, and if you win, he’ll lose. Since the house holds most of the cards, it has many ways to achieve the desired result.

Most forex houses “bucket” customer orders—accept them without executing any trades. They charge spreads, commissions, interest, etc. for non-existent trades. I received the clearest explanation of their game from a chatty head dealer at a major European forex house (which is now expanding worldwide, with branches in the United States—I see their billboards in New York).

That forex house accepts any trade in any currency pair, whether long or short, but always shifts the bid-ask spread to put itself at an advantage from the get-go. Those so-called “trades” never go anywhere—they’re only kept as electronic entries in the firm’s books. The forex house charges interest if its customers take their phantom “positions” overnight, even though there is never any position, since the house simply holds the opposite side of each trade. The only time the firm goes to the legitimate market is when multiple client orders cluster on the same side of the same currency pair in excess of a million dollars—that’s when the house hedges its own exposure in the real market.

When you trade stocks, options, or futures, your broker buys or sells on your behalf, earning a commission for this service, and doesn’t care whether you win or lose. This is great, because he has no incentive to push you into losing. On the other hand, a forex house that buckets your orders wants you to lose, so that it can win. In addition to shifting bid-ask spreads and charging interest on non-existent positions, it may even charge a daily “resettlement fee”—the full bid-ask spread for every day you hold a trade.

Forex shops help ensure their clients’ demise by offering homicidal leverage. I’ve seen them offer leverage of 100:1 and even 400:1. A newcomer who scrapes together a $1,000 stake can suddenly control a position worth a hundred thousand dollars. This means that the slightest price wiggle against him is guaranteed to wipe out his equity. That’s why those shops confidently keep clients’ money in-house, never transmitting their trades to the real market—why share the loot with anyone else? They are so certain of their clients’ demise that many compensate employees with a percentage of the client deposits that they bring in—funds deposited with a forex house are as good as theirs.

“The market has long been plagued by swindlers preying on the gullible,” according to The New York Times. “The average individual foreign-exchange-trading victim loses about $15,000, according to CFTC records,” writes The Wall Street Journal. Currency trading “has become the fraud du jour,” according to Michael Dunn of the U.S. Commodity Futures Trading Commission.

In August 2008, the CFTC set up a special task force to deal with growing foreign exchange fraud. In January 2010, the CFTC identified a “number of improper practices” in the retail foreign exchange market, “among them solicitation fraud, a lack of transparency in the pricing and execution of transactions, unresponsiveness to customer complaints, and the targeting of unsophisticated, elderly, low net worth and other vulnerable individuals.” It proposed new rules limiting leverage to 10 to 1.

Frauds may include churning customer accounts, selling useless software, improperly managing “managed accounts,” false advertising, and Ponzi schemes. All the while, promoters claim that trading foreign exchange is a road to profits.

The real forex market is a zero sum game, in which well-capitalized professional traders, many of whom work for banks, devote full-time attention to trading. An inexperienced retail trader has a significant information disadvantage. The retail trader always pays the bid-ask spread, which lowers his odds of winning. Retail forex traders are almost always undercapitalized and subject to the problem of “gambler’s ruin.” Even in a fair game between two players, the one with the lower amount of capital has a higher probability of going bust in the long run.

Having observed forex shops for decades, I was amused to see what my best student did when he became interested in forex. This multimillionaire stock trader decided to check out forex houses by opening large accounts and then waiting for the night, when forex trading was at its thinnest. That’s when he placed his orders, always of a very unusual and atypical size, and watched the tape. There were only two houses that showed his orders on tape—the rest, apparently, got bucketed.

I enjoy trading currencies, but wouldn’t go near a forex house. Instead, I trade electronic currency futures. That’s what I recommend to anyone interested in trading foreign exchange. Futures brokers work for you, not against you; futures spreads are more narrow, commissions more reasonable, and no interest is charged for the privilege of holding a position. There are contracts for most major currency pairs and even mini-contracts for euro/dollar and yen/dollar.

One of the real challenges of currencies is that they move around the clock. You may enter a trade, analyze it in the evening, and decide to take profits the following day. When you wake up, there are no profits to be taken. The turning point you saw coming has already come and gone, only not in the United States, but in Asia or Europe. Someone had picked your pocket while you slept!

Major financial institutions deal with this problem by using the system of “passing the book.” A bank may open a position in Tokyo, manage it intraday, and then transfer it to its London branch before closing for the night. London continues to manage that and other positions, and in the evening passes the book to New York, which manages it until it passes it back to Tokyo. Currencies follow the sun, and small traders can’t keep up with it. If you trade currencies, you either need to take a very long-term view and ignore daily fluctuations, or else day-trade and avoid overnight positions.