Friday, October 23, 2009

Trading and Level Playing Fields

Van Tharp Institute
By D.R. Barton, Jr. of Van Tharp Institute


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Level and Not-So-Level Playing Fields

I’m often asked about what I term the “low capital requirement” trading instruments. These areas (e.g., forex, options and futures, and especially the e-mini futures) have high leverage and the potential to turn a relatively small account into a much larger one.

Of course, the hottest of these markets is forex. Thanks to a huge advertising push, the promises of huge leverage and “no commissions” (more on that one later), forex market participation has exploded.

Unfortunately, the retail forex market is not yet a level playing field.

There are some real advantages in forex; however, none of them overcome the uneven playing field.

To be fair, I have traded forex through a retail forex broker so that I could understand the market. I also believe that there are enough positives about forex that we should continue to search actively for a way to participate in this market that provides a fair game for retail traders. For now, I have not found that venue.

If that’s so, then why is it growing so rapidly? Let’s look at forex advantages.

Forex Advantages

Huge Underlying Market. The forex market is underpinned by the interbank currency market, which facilitates international trade. So there are massive amounts of transactions made every day (though most of this is in the major currency pairs).

Extremely Low Capital Requirements. Some forex dealers allow you to open an account with just $200 dollars. I’ve even seen it as low as $100. Combined with the huge leverage, there is the dream of turning a very little pile of cash in to a very big one.

Big Leverage. Many forex houses provide 400-to-1 leverage, allowing account holders to control $400 dollars worth of currency for every $1 in their account (this leverage ratio typically drops as account sizes grows).

24-hour Market. Forex trades 24 hours a day, five+ days a week. And there is real action at the Tokyo and London opens.

Trending Markets. There are legitimate studies that show currencies among the most trending financial markets.

Forex Disadvantages

No Trading Exchange and Little Regulation. The real forex market is an interbank dealer market. Retail accounts are mostly handled by firms that allow customers to open small accounts and then the firm provides liquidity or takes the other side of your trade (rather than market makers and other trading participants). While this does not ensure abusive practices, it does open the door.

Trade Fills as Moving Targets. I have heard numerous reports about and personally experienced the posted bid-ask prices being moved, especially in fast markets. Some firms may be better at this than others, but the problem appears to be pervasive.

Higher Transaction Costs. While there are no commissions, the forex firms do make the bid-ask spread and profit from widened spreads during fast markets. These issues combine to make costs the same or at times significantly higher than other markets.

The bottom line is that the retail forex market is still a bit like the Wild West when compared to other markets. This uneven playing field means that the edge provided by your trading strategy has to be even bigger than normal.

Until we’ve found forex firms that address the “uneven playing field” issues, we think it is more prudent to trade currencies on the futures exchanges such as the CME.

Trade a Market with a Truly Level Playing Field

In futures, e-mini index futures are quite a phenomenon. They have grown unlike any other instrument. E-mini contracts were started by the Chicago Mercantile Exchange (CME) in 1998 with the S&P 500 e-mini.

As of the first quarter of 2007, the S&P e-mini was trading 4.5 times the dollar volume of the large S&P 500 contract. Today, the e-mini trades more than 12 to 15 times the volume of the pit traded contract! There are many reasons for its popularity.

I’ll share just a few here:

The e-mini contract is traded electronically on a platform called Globex.

Trades are executed instantaneously and are relatively error-free compared to pit traded contracts that may require several human interactions before orders are executed.

The smaller size and therefore reduced margin requirements of the e-mini contracts allow a high degree of retail participation.

The immense popularity of the S&P e-mini has led to the creation of a number of other equity indexes trading electronically in the e-mini size. The most popular of these among traders are the Nasdaq Composites, Dow Industrial, the up and coming Midcap 400 and the Russell 2000. E-mini trading has also spread to commodities (e.g., gold, oil), bonds and currencies.

Let’s look at why traders love these instruments so much.

Leverage. One of the biggest advantages for e-mini trading is the high amount of leverage they offer. And for day traders, brokers increase this leverage further. Let’s look at the actual leverage available: the S&P e-mini trade unit is 50 times the S&P 500 Stock Index. Currently, that calculation is looks like this: $50 x 1070 = $53,500. The margin to control $54k worth of underlying stock is around $5.6k, giving you leverage of about 9.5:1 on your money. However, the day trading margins are dropped significantly with $1,000 margins still available and some reputable firms offering $500 margins. At these rates, you can increase your intraday margin to greater than 100:1!

But leverage is a double-edged sword that definitely cuts both ways. While such leverage allows for large returns on very little money, it also means that you could lose large amounts. In next week’s article, we’ll cover tools that allow us to use this leverage in a big way, even while protecting our downside.

Liquidity. Liquidity is usually thought of in terms of volume. It is the characteristic that gives us the ability to get in/out of trades both quickly and at a preferable price. E-mini index trading gives us exceptional liquidity and great fills with little slippage. These attributes allow us to take full advantage of the available leverage.

Scalability. There are certain types of trading that can only be used on a small scale and cannot be translated to larger volumes as larger position sizes are required. But e-mini index trading in general and S&P e-mini trading in particular are highly scalable. Getting virtually no-slippage fills on 200 S&P e-mini contracts is an extreme advantage to large scale traders.

Round-the-clock liquidity. The S&P e-mini has liquidity 23.5 hours a day, which gives another advantage—the effect of overnight gaps is greatly reduced. You can keep a stop in the market if you’re doing a swing trade and have your protection kick in at a time when your IBM stock is still sleeping.

The Best Market Keeps Getting Better

As I mentioned above, higher volatility equates to greater opportunity for day traders. Today’s markets, while not having the volatility of last fall or this past spring, still have good volatility. However, with moderate volatility, it is really important to be patient and wait for the 2 to 5 high quality set-ups that come almost every day.

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