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Manage the Risk

What is risk?

 

Whether it is investing, driving, or just walking down the street, everyone exposes themselves to risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to take on. If you invest in stocks and have trouble sleeping at night, you are probably taking on too much risk. (For more insight, see A Guide To Portfolio Construction.)

Risk is defined as the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment.

Those of us who work hard for every penny we earn have a harder time parting with money. Therefore, people with less disposable income tend to be, by necessity, more risk averse. On the other end of the spectrum, day traders feel if they aren't making dozens of trades a day there is a problem. These people are risk lovers.

When investing in stocks, bonds, or any investment instrument, there is a lot more risk than you'd think. In the next section, we'll take a look at the different kind of risk that often threaten investors' returns.



Different Types of Risk

Let's take a look at the two basic types of risk:

·         Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio. It is virtually impossible to protect yourself against this type of risk.

·         Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk. (We will discuss diversification later in this tutorial).

Now that we've determined the fundamental types of risk, let's look at more specific types of risk, particularly when we talk about stocks and bonds.

·         Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to be junk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are investment-grade, and which bonds are junk. (To read more, see Junk Bonds: Everything You Need To Know, What Is A Corporate Credit Rating and Corporate Bonds: An Introduction To Credit Risk.)

·         Country Risk - Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (For related reading, see What Is An Emerging Market Economy?)

·         Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.
 

·         Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. (To learn more, read How Interest Rates Affect The Stock Market.)

·         Political Risk - Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment.

·         Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the day-to-day fluctuation in a stock's price. Market risk applies mainly to stocks and options. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament", of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.

    
As you can see, there are several types of risk that a smart investor should consider and pay careful attention to.



The Risk-Reward Tradeoff

 

The risk-return tradeoff could easily be called the iron stomach test. Deciding what amount of risk you can take on is one of the most important investment decisions you will make.

The risk-return tradeoff is the balance an investor must decide on between the desire for the lowest possible risk for the highest possible returns. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.

The risk-free rate of return is usually signified by the quoted yield of "U.S. Government Securities" because the government very rarely defaults on loans. Let's suppose that the risk-free rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per year on his or her money. But who wants 6% when index funds are averaging 12-14.5% per year? Remember that index funds don't return 14.5% every year, instead they return -5% one year and 25% the next and so on. In other words, in order to receive this higher return, investors much also take on considerably more risk.

The following chart shows an example of the risk/return tradeoff for investing. A higher standard deviation means a higher risk:

 

 

In the next section, we'll show you what you can do to reduce the risk in your portfolio with an introduction to the diversification.



Diversifying Your Portfolio

 

With the stock markets bouncing up and down 5% every week, individual investors clearly need a safety net. Diversification can work this way and can prevent your entire portfolio from losing value.

Diversifying your portfolio may not be the sexiest of investment topics. Still, most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-range financial goals while minimizing your risk. Keep in mind, however that no matter how much diversification you do, it can never reduce risk down to zero. (For related reading, see Introduction To Diversification and The Importance Of Diversification.)

What do you need to have a well diversified portfolio? There are three main things you should do to ensure that you are adequately diversified:


1.       Your portfolio should be spread among many different investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate.

2.       Your securities should vary in risk. You're not restricted to picking only blue chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas. Keep in mind that this doesn't mean that you need to jump into high-risk investments such as penny stocks!

3.       Your securities should vary by industry, minimizing unsystematic risk to small groups of companies.
Another question people always ask is how many stocks they should buy to reduce the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified stocks, you are very close to optimal diversification. This doesn't mean buying 12 internet or tech stocks will give you optimal diversification. Instead, you need to buy stocks of different sizes and from various industries.

 
 

Price Volatility Vs. Leverage

The concept of price volatility versus account volatility is centered around the two core emotions traders must face: fear and greed. These emotions act as checks and balances for the trader. These two emotions must be in balance in order to keep a trader (and his or her portfolio) on track. Typically, we see that traders are attracted to volatile price swings by the possibility of large gains; in other words, they let greed get out of balance with fear.

But huge price swings in any market tend to be anomalies where crowd mentality has taken the price out of line with fundamentals. When this happens, one of two things will occur: either the fundamentals will change to meet the new price, or the price will come back into line with the real fundamentals. Either way, prices typically become erratic when this happens. If you use any type of technical analysis in your trading, you probably already know that this can make reading the market very frustrating. This activity often renders technical analysis very difficult to master.

Price Volatility and Stops
Erratic price swings make the market difficult to analyze and trade. Worse yet, it makes it difficult to calculate and control risk. If a market makes erratic swings up, leaving gaps on the chart, it can just as easily do that on the downside. Therefore, not only is it difficult to get a handle on true market momentum and directions, the risk that the market will gap down past your stop is very high.

This is an important point about stops. A stop becomes a market order when the market trades at or through your price. For example, on the sell side, a stop to sell gold at $650 will be executed at the next possible order when the market trades at or below $650. If the next possible trade from $650 is $649.90, you don't have much to worry about. But what happens when the market trades at $650.10 and then gaps lower to $645? That could be a problem for some accounts.


What Goes up, Must Come Down
Volatile markets can be dangerous to trade from a risk management perspective, but they also can be difficult to trade from a directional standpoint. There are some clichés to keep in mind. One that is especially important for trading the long side is that markets tend to come down faster than they go up. As an example, consider silver futures during 2006.

Silver took about four and a half months in 2006 (from Jan. 25, 2006, to May 11, 2006) to make the move from $9.50 per ounce to a high of $15.20. Following that high, it only took one month and four days for the move to retreat, making a low of $9.45 on June 14, 2006. Stocks, futures and currencies are all susceptible to this principle.


What Markets Should I Trade?
Choosing the right market in which to trade involves weighing many factors. Quite often, beginner traders wonder about learning to trade certain markets. Based on their questions, it is clear that their first decision is often to choose a market to trade, rather than other factors like how much capital to work with, or what the risk factors might be. However, decisions about what market to trade should actually come at the end of the planning process.

A primary reason for this is that the swings of the market you are trading must fit not only your profit objectives, but your risk tolerance as well. If you are looking to trade predetermined markets without a solid reason as to why, you need to throw that idea out the window and begin your plan from scratch. (It is possible that you may end up with the same market at the end, but you need to substantiate your reason to trade the markets you are trading.)

Begin by determining the amount of risk capital you have available. You will need to determine what type of trading suits not only your personality, but also the time you have available to trade. Make sure to decide on the type of profits you are targeting and the amount of risk you are willing to take. Only then will you be ready to develop, build and/or fine-tune your trading plan. Only from that point is it logical to begin analyzing markets.

The Bottom Line
The markets you choose to trade must fit all of the above factors. The potential swings in the market must fit your trading time horizon and your risk parameters. Your profit objective must reasonably fit the market as well. From there, adjustments can be made to your leverage to increase the potential returns on invested margin. Just remember that with increased leverage comes increased risk.


Read more: http://www.investopedia.com/articles/optioninvestor/07/volatility_leverage.asp#ixzz1wWAIwNTU

Dividends, Interest Rates And Their Effect On Stock Options

While the math behind options-pricing models may seem daunting, the underlying concepts are not. The variables used to come up with a "fair value" for a stock option are the price of the underlying stock, volatility, time, dividends and interest rates. The first three deservedly get most of the attention because they have the largest effect on option prices. But it is also important to understand how dividends and interest rates affect the price of a stock option. These two variables are crucial to understanding when to exercise options early.

Black Scholes Doesn't Account for Early Exercise

The first option pricing model, the Black Scholes model, was designed to evaluate European-style options, which don't permit early exercise. So Black and Scholes never addressed the problem of when to exercise an option early and how much the right of early exercise is worth. Being able to exercise an option at any time should theoretically make an American-style option more valuable than a similar European-style option, although in practice there is little difference in how they are traded.

Different models were developed to accurately price American-style options. Most of these are refined versions of the Black Scholes model, adjusted to take into account dividends and the possibility of early exercise. To appreciate the difference these adjustments can make, you first need to understand when an option should be exercised early.

And how will you know this? In a nutshell, an option should be exercised early when the option's theoretical value is at parity and its delta is exactly 100. That may sound complicated, but as we discuss the effects interest rates and dividends have on option prices, I will also bring in a specific example to show when this occurs. First, let's look at the effects interest rates have on option prices, and how they can determine if you should exercise a put option early.

The Effects of Interest Rates

An increase in interest rates will drive up call premiums and cause put premiums to decrease. To understand why, you need to think about the effect of interest rates when comparing an option position to simply owning the stock. Since it is much cheaper to buy a call option than 100 shares of the stock, the call buyer is willing to pay more for the option when rates are relatively high, since he or she can invest the difference in the capital required between the two positions.

When interest rates are steadily falling to a point where the Fed Funds' target is down to around 1.0% and short-term interest rates available to individuals are around 0.75% to 2.0% (like in late 2003), interest rates have a minimal effect on option prices. All the best option analysis models include interest rates in their calculations using a risk-free interest rate such as U.S. Treasury rates.

Interest rates are the critical factor in determining whether to exercise a put option early. A stock put option becomes an early exercise candidate anytime the interest that could be earned on the proceeds from the sale of the stock at the strike price is large enough. Determining exactly when this happens is difficult, since each individual has different opportunity costs, but it does mean that early exercise for a stock put option can be optimal at any time provided the interest earned becomes sufficiently great.

The Effects of Dividends

It's easier to pinpoint how dividends affect early exercise. Cash dividends affect option prices through their effect on the underlying stock price. Because the stock price is expected to drop by the amount of the dividend on the ex-dividend date, high cash dividends imply lower call premiums and higher put premiums.

While the stock price itself usually undergoes a single adjustment by the amount of the dividend, option prices anticipate dividends that will be paid in the weeks and months before they are announced. The dividends paid should be taken into account when calculating the theoretical price of an option and projecting your probable gain and loss when graphing a position. This applies to stock indices as well. The dividends paid by all stocks in that index (adjusted for each stock's weight in the index) should be taken into account when calculating the fair value of an index option.

Because dividends are critical to determining when it is optimal to exercise a stock call option early, both buyers and sellers of call options should consider the impact of dividends. Whoever owns the stock as of the ex-dividend date receives the cash dividend, so owners of call options may exercise in-the-money options early to capture the cash dividend. That means early exercise makes sense for a call option only if the stock is expected to pay a dividend prior to expiration date.

Traditionally, the option would be exercised optimally only on the day before the stock's ex-dividend date. But changes in the tax laws regarding dividends mean that it may be two days before now if the person exercising the call plans on holding the stock for 60 days to take advantage of the lower tax for dividends. To see why this is, let's look at an example (ignoring the tax implications since it changes the timing only).

Say you own a call option with a strike price of 90 that expires in two weeks. The stock is currently trading at $100 and is expected to pay a $2 dividend tomorrow. The call option is deep in-the-money, and should have a fair value of 10 and a delta of 100. So the option has essentially the same characteristics as the stock. You have three possible courses of action:
  1. Do nothing (hold the option).
  2. Exercise the option early.
  3. Sell the option and buy 100 shares of stock.

Which of these choices is best? If you hold the option, it will maintain your delta position. But tomorrow the stock will open ex-dividend at 98 after the $2 dividend is deducted from its price. Since the option is at parity, it will open at a fair value of 8, the new parity price, and you will lose two points ($200) on the position.

If you exercise the option early and pay the strike price of 90 for the stock, you throw away the 10-point value of the option and effectively purchase the stock at $100. When the stock goes ex-dividend, you lose $2 per share when it opens two points lower, but also receive the $2 dividend since you now own the stock.

Since the $2 loss from the stock price is offset by the $2 dividend received, you are better off exercising the option than holding it. That is not because of any additional profit, but because you avoid a two-point loss. You must exercise the option early just to ensure you break even.

What about the third choice - selling the option and buying stock? This seems very similar to early exercise, since in both cases you are replacing the option with the stock. Your decision will depend on the price of the option. In this example, we said the option is trading at parity (10) so there would be no difference between exercising the option early or selling the option and buying the stock.

But options rarely trade exactly at parity. Suppose your 90 call option is trading for more than parity, say $11. Now if you sell the option and purchase the stock you still receive the $2 dividend and own a stock worth $98, but you end up with an additional $1 you would not have collected had you exercised the call.

Alternately, if the option is trading below parity, say $9, you want to exercise the option early, effectively getting the stock for $99 plus the $2 dividend. So the only time it makes sense to exercise a call option early is if the option is trading at or below parity, and the stock goes ex-dividend tomorrow.

Conclusion

Although interest rates and dividends are not the primary factors affecting an option's price, the option trader should still be aware of their effects. In fact, the primary drawback I have seen in many of the option analysis tools available is that they use a simple Black Scholes model and ignore interest rates and dividends. The impact of not adjusting for early exercise can be great, since it can cause an option to seem undervalued by as much as 15%.

Remember, when you are competing in the options market against other investors and professional market makers, it makes sense to use the most accurate tools available.

Read more: http://www.investopedia.com/articles/optioninvestor/03/121003.asp#ixzz1wW9Otvrp


Short Selling: Introduction

Have you ever been absolutely sure that a stock was going to decline and wanted to profit from its regrettable demise? Have you ever wished that you could see your portfolio increase in value during a bear market? Both scenarios are possible. Many investors make money on a decline in an individual stock or during a bear market, thanks to an investing technique called short selling. (For related reading, see When To Short A Stock.)

Short selling is not complex, but it's a concept that many investors have trouble understanding. In general, people think of investing as buying an asset, holding it while it appreciates in value, and then eventually selling to make a profit. Shorting is the opposite: an investor makes money only when a shorted security falls in value.

Short selling involves many unique risks and pitfalls to be wary of. The mechanics of a short sale are relatively complicated compared to a normal transaction. As always, the investor faces high risks for potentially high returns. It's essential that you understand how the whole process works before you get involved.


Short Selling: What Is Short Selling?


First, let's describe what short selling means when you purchase shares of stock. In purchasing stocks, you buy a piece of ownership in the company. The buying and selling of stocks can occur with a stock broker or directly from the company. Brokers are most commonly used. They serve as an intermediary between the investor and the seller and often charge a fee for their services.
When using a broker, you will need to set up an account. The account that's set up is either a cash account or a margin account. A cash account requires that you pay for your stock when you make the purchase, but with a margin account the broker lends you a portion of the funds at the time of purchase and the security acts as collateral.

When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price.

Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. That may sound confusing, but it's actually a simple concept. (To learn more, read Benefit From Borrowed Securities.)

Still with us? Here's the skinny: when you short sell a stock, your broker will lend it to you. The stock will come from the brokerage's own inventory, from another one of the firm's customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must "close" the short by buying back the same number of shares (called covering) and returning them to your broker. If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

Most of the time, you can hold a short for as long as you want, although interest is charged on margin accounts, so keeping a short sale open for a long time will cost more However, you can be forced to cover if the lender wants the stock you borrowed back. Brokerages can't sell what they don't have, so yours will either have to come up with new shares to borrow, or you'll have to cover. This is known as being called away. It doesn't happen often, but is possible if many investors are short selling a particular security.

Because you don't own the stock you're short selling (you borrowed and then sold it), you must pay the lender of the stock any dividends or rights declared during the course of the loan. If the stock splits during the course of your short, you'll owe twice the number of shares at half the price. (To learn more about stock splits, read Understanding Stock Splits.)

Short Selling: Why Short?

Generally, the two main reasons to short are to either speculate or to hedge.

Speculate
When you speculate, you are watching for fluctuations in the market in order to quickly make a big profit off of a high-risk investment. Speculation has been perceived negatively because it has been likened to gambling. However, speculation involves a calculated assessment of the markets and taking risks where the odds appear to be in your favor. Speculating differs from hedging because speculators deliberately assume risk, whereas hedgers seek to mitigate or reduce it. (For more insight, see What is the difference between hedging and speculation?)

Speculators can assume a high loss if they use the wrong strategies at the wrong time, but they can also see high rewards. Probably the most famous example of this was when George Soros "broke the Bank of England" in 1992. He risked $10 billion that the British pound would fall and he was right. The following night, Soros made $1 billion from the trade. His profit eventually reached almost $2 billion. (For more on this trade, see The Greatest Currency Trades Ever Made.)

Speculators can benefit the market because they increase trading volume, assume risk and add market liquidity. However, high amounts of speculative purchases can contribute to an economic bubble and/or a stock market crash.

Hedge
For reasons we'll discuss later, very few sophisticated money managers short as an active investing strategy (unlike Soros). The majority of investors use shorts to hedge. This means they are protecting other long positions with offsetting short positions.

Hedging can be a benefit because you're insuring your stock against risk, but it can also be expensive and a basis risk can occur. (To learn more about hedging, read A Beginner's Guide To Hedging.)

Restrictions
Many restrictions have been placed on the size, price and types of stocks traders are able to short sell. For example, penny stocks cannot be sold short, and most short sales need to be done in round lots. The Securities Exchange Commission (SEC) has these restrictions in place to prevent the manipulation of stock prices.

As of January 2005, short sellers were also required to comply with the rules set in place by "Regulation SHO", which modernized the rules overseeing short selling and aimed to provide safeguards against "naked short selling." For instance, sellers had needed to show that they could locate and get the securities they intended to short. The regulation also created a list of securities showing a high level of persistent sales to deliver.

In July of 2007, the SEC eliminated the uptick, or zero plus tick, rule. This rule required that every short sale transaction be entered at a higher price than that of the previous trade and kept short sellers from adding to the downward momentum of an asset when it was already experiencing sharp declines. The rule has been around since the creation of the SEC in 1934. One of the reasons it was put in place was to slow rapid and sudden declines in share prices that can occur as a result of short selling.

In July of 2008, the SEC used its emergency powers to put an end to market manipulations, such as spreading negative rumors about a company's performance and sharp price declines. The markets had been volatile as a result of the of mortgage and credit crisis, and the SEC wanted to establish a renewed confidence. For a month, it didn't allow naked short selling on the stocks of 19 major investment and commercial banks, which included the mortgage finance companies Fannie Mae and Freddie Mac.


The SEC took further measures in September of 2008, once again using its emergency authority to issue six orders to minimize abuses. This included a move to halt short selling in shares of 799 companies in cooperation with the United Kingdom's Financial Service Authority. 170 companies were later included in the ban, which ended after the passage of the $700 billion U.S. bailout plan in October 2008. Another order required short sellers get a sale and immediately close it by making sure the shares were delivered. It later became a rule.

Who Shorts?
Some insiders indicate that it takes a certain type of person to short stocks.

Many short sellers have been depicted as pessimists who are rooting for a company's failure, but they've also been described as disciplined and confident in their judgment.

Sellers are typically:
  • wealthy sophisticated investors
  • hedge funds
  • large institutions
  • day traders
Short selling isn't for everyone. It involves a great amount of time and dedication. Short sellers need to be informed, skilled and experienced investors in order to succeed.

They must know:
  • how securities markets work
  • trading techniques and strategies
  • market trends
  • the firm's business operations

Short Selling: The Transaction


Suppose that, after hours of painstaking research and analysis, you decide that company XYZ is dead in the water. The stock is currently trading at $65, but you predict it will trade much lower in the coming months. In order to capitalize on the decline, you decide to short sell shares of XYZ stock. Let's take a look at how this transaction would unfold.

Step 1
: Set up a margin account. Remember, this account allows you to borrow money from the brokerage firm using your investment as collateral.

Step 2: Place your order by calling up the broker or entering the trade online. Most online brokerages will have a check box that says "short sale" and "buy to cover." In this case, you decide to put in your order to short 100 shares.

Step 3: The broker, depending on availability, borrows the shares. According to the SEC, the shares the firm borrows can come from:
  • the brokerage firm's own inventory
  • the margin account of one of the firm's clients
  • another brokerage firm
You should also be mindful of the margin rules and know that fees and charges can apply. For instance, if the stock has a dividend, you need to pay the person or firm making that loan. (To learn more, read the Margin Trading tutorial.)

Step 4: The broker sells the shares in the open market. The profits of the sale are then put into your margin account.

One of two things can happen in the coming months:

The Stock Price Sinks (stock goes to $40)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $40 -$4,000
Your Profit $2,500


The Stock Price Rises (stock goes to $90)
Borrowed 100 shares of XYZ at $65 $6,500
Bought Back 100 shares of XYZ at $90 -$9,000
Your Profit -$2,500

Clearly, short selling can be profitable. But then, there's no guarantee that the price of a stock will go the way you expect it to (just as with buying long). Shorter sellers use an endless number of metrics and ratios to find shortable candidates. Some use a similar stock picking methodology to the longs, but just short the stocks that come out worst. Others look for insider trading, changes in accounting policy, or bubbles waiting to pop.

One indicator specific to shorts that is worth mentioning is short interest. Short interest is the total number of stocks, securities or commodity shares in an account or in the markets that have been sold short, but haven't been repurchased in order to close the short position. It serves as a barometer for a bearish or bullish market. For instance, the higher the short interest, the more people will anticipate a downturn.

Short Selling: The Risks

Now that we've introduced short selling, let's make one thing clear: shorting is risky. Actually, we'll rephrase that. Shorting is very, very risky. It's not unlike running with the bulls in Spain: you can either have a great time, or you can get trampled.

You can think of the outcome of a short sale as basically the opposite of a regular buy transaction, but the mechanics behind a short sale result in some unique risks.
  1. Short selling is a gamble. History has shown that, in general, stocks have an upward drift. Over the long run, most stocks appreciate in price. For that matter, even if a company barely improves over the years, inflation should drive its stock price up somewhat. What this means is that shorting is betting against the overall direction of the market.

So, if the direction is generally upward, keeping a short position open for a long period can become very risky. (To learn more, read Stocks Are No.1 and The Stock Market: A Look Back.)

  • Losses can be infinite. When you short sell, your losses can be infinite. A short sale loses when the stock price rises and a stock is (theoretically, at least) not limited in how high it can go. For example, if you short 100 shares at $65 each hoping to make a profit but the shares increase to $90 apiece, you end up losing $2,500. On the other hand, a stock can't go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business and the stock loses its entire value.

  • Shorting stocks involves using borrowed money. This is known as margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as collateral. Just as when you go long on margin, it's easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you'll be subject to a margin call, and you'll be forced to put in more cash or liquidate your position. (We won't cover margin in detail here, but you can read more in our Margin Trading tutorial.)

  • Short squeezes can wring the profit out of your investment. When stock prices go up short seller losses get higher, as sellers rush to buy the stock to cover their positions. This rush creates a high demand for the stock quickly driving up the price even further. This phenomenon is known as a short squeeze. Usually, news in the market will trigger a short squeeze, but sometimes traders who notice a large number of shorts in a stock will attempt to induce one. This is why it's not a good idea to short a stock with high short interest. A short squeeze is a great way to lose a lot of money extremely fast. (To learn more, see Short Squeeze The Last Drop Of Profit From Market Moves.)

  • Even if you're right, it could be at the wrong time. The final and largest complication is being right too soon. Even though a company is overvalued, it could conceivably take a while to come back down. In the meantime, you are vulnerable to interest, margin calls and being called away. Academics and traders alike have tried for years to come up with explanations as to why a stock's market price varies from its intrinsic value. They have yet to come up with a model that works all the time, and probably never will.Take the dotcom bubble, for example. Sure, you could have made a killing if you shorted at the market top in the beginning of 2000, but many believed that stocks were grossly overvalued even a year earlier. You'd be in the poorhouse now if you had shorted the Nasdaq in 1999! That's when the Nasdaq was up 86%, although two-thirds of the stocks declined. This is contrary to the popular belief that pre-1999 valuations more accurately reflected the Nasdaq. However, it wasn't until three years later, in 2002, that the Nasdaq returned to 1999 levels.

  • Momentum is a funny thing. Whether in physics or the stock market, it's something you don't want to stand in front of. All it takes is one big shorting mistake to kill you. Just as you wouldn't jump in front of a pack of stampeding bulls, don't fight against the trend of a hot stock.

    Short Selling: Ethics And The Role Of Short Selling

    It's safe to say that short sellers aren't the most popular people on Wall Street. Many investors see short selling as "un-American" and "betting against the home team" because these sellers are perceived to seek out troubled companies.
    Some critics even believe that short sales are a major cause of market downturns, such as the crash in 1987. There isn't a whole lot of evidence to support this, as other factors such as derivatives and program trading also played a massive role, but two years after the crash, the U.S. government held the 1989 House subcommittee hearing on short selling. Lawmakers wanted to look at the effects short sellers had on small companies and examined the need for regulation after allegations of widespread manipulation by short sellers of over-the-counter stocks. SEC officials reassured the public that manipulations hadn't been uncovered and more rules would be put in place. (To learn more, read Questioning The Virtue Of A Short Sale and The Uptick Rule: Does It Keep Bear Markets Ticking?) But despite its critics, it's tough to deny that short selling makes an important contribution to the market by:
    • Adding liquidity to share transactions. The additional buying and selling reduces the difference between the price at which shares can be bought and sold.
    • Driving down overpriced securities by lowering the cost to execute a trade
    • Increasing the overall efficiency of the markets by quickening price adjustments
    • Acting as the first line of defense against financial fraud. For instance, in 2001, famed short seller James Chanos identified fraudulent accounting practices that occurred with the Enron Corporation, an energy-trading and utilities company. The company's activity became known as the Enron scandal when the company was found to have inflated its revenues. It filed Chapter 11 bankruptcy at the end of 2001. (To learn more about this scandal, see The Biggest Stock Scams Of All Time.)

    While the conflicts of interest from investment banking keep some analysts from giving completely unbiased research, work from short sellers is often regarded as being some of the most detailed and highest quality research in the market. It's been said that short sellers actually prevent crashes because they provide a voice of reason during raging bull markets.However, short selling also has a dark side, courtesy of a small number of traders who are not above using unethical tactics to make a profit. Sometimes referred to as the "short and distort," this technique takes place when traders manipulate stock prices in a bear market by taking short positions and then using a smear campaign to drive down the target stocks. This is the mirror version of the pump and dump, where crooks buy stock (take a long position) and issue false information that causes the target stock's price to increase. Short selling abuse like this has grown along with internet trading and the growing trend of small investors and online trading.

    Short Selling: Conclusion

    Short selling is another technique you can add to your trading toolbox. That is, if it fits with your risk tolerance and investing style. Short selling provides a sizable opportunity with a hefty dose of risk. We hope this tutorial has enabled you to understand whether it's something you would like to pursue. Let's recap:

    • In a short sale, an investor borrows shares, sells them and must eventually return the same shares (cover). Profit (or loss) is made on the difference between the price at which the shares are borrowed compared to when they are returned.
    • An investor makes money only when a shorted security falls in value.
    • Short selling is done on margin, and so is subject to the rules of margin trading.
    • The shorter must pay the lender any dividends or rights declared during the course of the loan.
    • The two reasons for shorting are to speculate and to hedge.
    • There are restrictions as to what stocks can be shorted and when a short can be carried out (uptick rule).
    • Short interest tells us the number of shares that have already been sold short in a security.
    • Short selling is very risky. You can lose more money than you invest but are limited to 100% profit on the upside.
    • A short squeeze is when a large number of short sellers try to cover their positions at the same time, driving up the price of a stock.
    • Even though a company is overvalued, it may take a long time for it to come back down. Fighting the trend almost always leads to trouble.
    • Critics of short selling see it as unethical and bad for the market.
    • Short selling contributes to the market by providing liquidity, efficiency and acting as a voice of reason in bull markets.
    • Some unethical traders spread false information in an attempt to drive the price of a stock down and make a profit by selling short.

    An Introduction To Day Trading

    Day trading is defined as the buying and selling of a security within a single trading day. Typically, day traders are well educated and well funded. They utilize high amounts of leverage and short-term trading strategies to capitalize on small price movements in highly liquid stocks or currencies. Day traders serve two critical functions in the marketplace: they keep the markets running efficiently via arbitrage and they provide much of the markets' liquidity (especially in the stock market). This article will take an objective look at day trading, who does it and how it is done.

    The Controversy

    Search "day trading" on Google and you will see why there is controversy! The profit potential of day trading is perhaps one of the most debated (and misunderstood) topics on Wall Street. Countless internet scams have capitalized on this confusion by promising enormous returns in a short period. Meanwhile, the media continues to promote this type of trading as a get-rich-quick scheme that always works. The truth lies somewhere in the middle. There are those who engage in this type of trading without sufficient knowledge, or some even admittedly for a gambler's high; however, there are day traders who are able to make a successful living.

    Many professional money managers and financial advisors shy away from day trading, arguing that in most cases the reward does not justify the risk. They often cite that no day trader is world renown, whereas icons like Warren Buffett and Peter Lynch are a testament to the success that can be attained by more traditional forms of investing. Conversely, those who do day trade insist there is profit to be made. They say the success rate is inherently lower as a result of the higher complexity and necessary risk of day trading, combined with all the related scams.

    Overall, the street remains divided on the issue. At the very least they agree that day trading is not for everyone and involves significant risks. Moreover, it demands an in-depth understanding of how the markets work and various strategies for profiting in the short term. Now we'll take a look at the various aspects of day trading.

    Characteristics of a Day Trader

    This article will focus on professional day traders - that is, those who trade for a living, not simply as a hobby or for a "gambling high." These traders are typically well-established in the field and have in-depth knowledge of the marketplace. Here are some of the prerequisites to day trading:

    • Knowledge and Experience in the Marketplace: Individuals who attempt to day trade without an understanding of market fundamentals often end up losing money.

    • Sufficient Capital: One cannot expect to make money day trading. Day traders use only risk capital, which they can afford to lose. Not only does this protect them from financial ruin, but it also helps eliminate emotion from their trading. A large amount of capital is often necessary to capitalize effectively on intra-day price movements.

    • A Strategy: A trader needs an edge over the rest of the market. There are several different strategies that day traders utilize, including swing trading, arbitrage and trading news, among others. These strategies are refined until they produce consistent profits and effectively limit losses.


    • Discipline: A profitable strategy is useless without discipline. Many day traders end up losing a lot of money because they fail to make trades that meet their own criteria. As they say, "Plan the trade and trade the plan." Success is impossible without discipline.

    Day Trading for a Living
    There are two primary divisions of professional day traders: those who work alone and/or those who work for a larger institution. Most day traders who trade for a living work for a large institution. The fact is these people have access to things individual traders could only dream of: a direct line to a dealing desk, large amounts of capital and leverage, expensive analytical software and much more. These traders are typically the ones looking for easy profits that can be made from arbitrage opportunities and news events. The resources to which they have access allow them to capitalize on these less risky day trades before individual traders can react.

    Individual traders often manage other people's money or simply trade with their own. Few of them have access to a dealing desk; however, they often have strong ties to a brokerage (due to the large amounts of commission spending) and access to other resources. However, the limited scope of these resources prevents them from competing directly with institutional day traders; instead, they are forced to take more risks. Individual traders typically day trade using technical analysis and swing trades - combined with some leverage - to generate adequate profits on such small price movements in highly liquid stocks.

    Trading

    Day trading demands access to some of the most complex financial services and instruments in the marketplace. Day traders require:

    • Access to the Trading Desk: This is usually reserved for traders working for larger institutions or those who manage large amounts of money. The dealing desk provides these traders with instantaneous order executions, which can become important, especially when sharp price movements occur. For example, when an acquisition is announced, day traders looking at merger arbitrage can get their orders in before the rest of the market, taking advantage of the price differential.

    • Multiple News Sources: In the movie "Wall Street" Gordon Gekko says that "information is the most important commodity when trading." News provides the majority of opportunities day traders capitalize on, so it is imperative to be the first to know when something big happens. The typical trading room contains access to the Dow Jones Newswire, televisions showing CNBC and other news agencies, as well as software that constantly analyzes various other news sources for important stories.

    • Analytical Software: Trading software is an expensive necessity for most day traders. Those who rely on technical indicators or swing trades rely more on software than news. This software typically contains many features, including:
      • Automatic pattern recognition - This means that the trading program identifies technical indicators like flags, channels and even more complex indicators like Elliott Wave patterns.
      • Genetic and neural applications - These are programs that utilize neural networks and genetic algorithms to perfect trading systems to make more accurate predictions of future price movements.
      • Broker integration - Some of these applications even interface directly with the brokerage, which allows for instantaneous and even automatic execution of trades. This is helpful for eliminating emotion from trading and improving execution times.
      • Back testing - This allows traders to look at how a certain strategy would have performed in the past in order to predict more accurately how it will perform in the future (although past performance is not always indicative of future results).


    Combined these tools provide traders with an edge over the rest of the marketplace. It is easy to see why, without them, so many inexperienced traders lose money.

    The Bottom Line

    Although day trading has become somewhat of a controversial phenomenon, its prevalence is undeniable. Day traders, both institutional and individual, play an important role in the marketplace by keeping the markets efficient and liquid. Some argue that individuals should stay away from day trading, while others argue that it is a viable means to profit. Although it is becoming increasingly popular among inexperienced traders, it should be left primarily to those with the skills and resources needed to succeed.

    Day Trading Strategies For Beginners


    When people use the term "day trading", they mean the act of buying and selling a stock within the same day. Day traders seek to make profits by leveraging large amounts of capital to take advantage of small price movements in highly liquid stocks or indexes. Here we look at some common day trading strategies that can be used by retail traders.


    Entry Strategies
    Certain stocks are ideal candidates for day trading. A typical day trader looks for two things in a stock: liquidity and volatility. Liquidity allows you to enter and exit a stock at a good price (i.e. tight spreads and low slippage). Volatility is simply a measure of the expected daily price range - the range in which a day trader operates. More volatility means greater profit or loss.

    Once you know what kinds of stocks you are looking for, you need to learn how to identify possible entry points. There are three tools you can use to do this:

    • Intraday Candlestick Charts - Candles provide a raw analysis of price action.
    • Level II Quotes/ECN - Level II and ECN provide a look at orders as they happen.
    • Real-Time News Service - News moves stocks. This tells you when news comes out.
    We will look at the intraday candlestick charts and focus on the following three factors:

    • Candlestick Patterns - Engulfings and dojis
    • Technical Analysis - Trendlines and triangles
    • Volume - Increasing or decreasing volume
    There are many candlestick setups that we can look for to find an entry point. If properly used, the doji reversal pattern (highlighted in yellow in Figure 1) is one of the most reliable ones.


    Figure 1: Looking at candlesticks - the highlighted doji signals a reversal.
    Typically, we will look for a pattern like this with several confirmations:
    • First, we look for a volume spike, which will show us whether traders are supporting the price at this level. Note that this can be either on the doji candle, or on the candles immediately following it.
    • Second, we look for prior support at this price level. For example, the prior low of day (LOD) or high of day (HOD).
    • Finally, we look at the Level II situation, which will show us all the open orders and order sizes.
    If we follow these three steps, we can determine whether the doji is likely to produce an actual turnaround, and we can take a position if the conditions are favorable. Typically, entry points are found using a combination of these three tools.

    Finding a Target
    Identifying a price target will depend largely on your trading style. Here is a brief overview of some common day trading strategies:

    Strategy
    Description
    Scalping
    Scalping is one of the most popular strategies, which involves selling almost immediately after a trade becomes profitable. Here the price target is obviously just after profitability is attained.
    Fading
    Fading involves shorting stocks after rapid moves upwards. This is based on the assumption that (1) they are overbought, (2) early buyers are ready to begin taking profits and (3) existing buyers may be scared out. Although risky, this strategy can be extremely rewarding. Here the price target is when buyers begin stepping in again.
    Daily Pivots
    This strategy involves profiting from a stock's daily volatility. This is done by attempting to buy at the low of the day (LOD) and sell at the high of the day (HOD). Here the price target is simply at the next sign of a reversal, using the same patterns as above.
    Momentum
    This strategy usually involves trading on news releases or finding strong trending moves supported by high volume. One type of momentum trader will buy on news releases and ride a trend until it exhibits signs of reversal. The other type will fade the price surge. Here the price target is when volume begins to decrease and bearish candles start appearing.

    You can see that, although the entries in day trading strategies typically rely on the same tools used in normal trading, the exits are where the differences occur. In most cases, however, you will be looking to exit when there is decreased interest in the stock (indicated by the Level II/ECN and volume).

    Determining a Stop-Loss
    When you trade on margin, you are far more vulnerable to sharp price movements than regular traders. Therefore, using stop-losses is crucial when day trading. One strategy is to set two stop losses:

    1. A physical stop-loss order placed at a certain price level that suits your risk tolerance. Essentially, this is the most you want to lose.
    2. A mental stop-loss set at the point where your entry criteria are violated. This means that if the trade makes an unexpected turn, you'll immediately exit your position.

    Retail day traders usually also have another rule: set a maximum loss per day that you can afford (both financially and mentally) to withstand. Whenever you hit this point, take the rest of the day off. Inexperienced traders often feel the need to make up losses before the day is over and end up taking unnecessary risks as a result.

    Evaluating and Tweaking Performance
    Many people get into day trading expecting to make triple digit returns every year with minimal effort. In reality, many day traders lose money. However, by using a well-defined strategy that you are comfortable trading, you can improve your chances of beating the odds.

    How do you evaluate performance? Most day traders evaluate performance not so much by a percentage of gain or loss, but rather by how closely they adhere to their individual strategies. In fact, it is far more important to follow your strategy closely than to try to chase profits. By keeping this mindset, you make it easier to identify where problems exist and how to solve them.

    The Bottom Line
    Day trading is a difficult skill to master. As a result, many of those who try it fail. But the techniques described above can help you create a profitable strategy and, with enough practice and consistent performance evaluation, you can greatly improve your chances of beating the odds.

    5 Rules For Picking Great Day Trade Entries

    Day trading involves isolating the current trend from market noise and then capitalizing on that trend through well-timed entries and profit taking. These factors play a crucial role in managing potential profit expectations and risk. Trading has many challenges, but by sticking to certain guidelines success is more likely. Since the market always moves in waves, on all time frames, rules can be created for exploiting this phenomenon. The following five rules will help traders find high profit potential, low risk, intra-day trades.

    1. Trade only with the current intra-day trend
    Trading with the trend allows for low risk entries and high profit potential if the trend continues. Intra-day trends do not continue indefinitely, reversals do occur, but usually one or two trades, and sometimes more, can be made before the trend reverses.

    Isolating the trend can be the difficult part. Trendlines provide a very simple and useful entry and stop loss strategy. Focus on trading with the dominant trend of the day. When that trend shifts, begin trading with the new trend. Figure 1 shows several short-term trends during a typical day.



    Figure 1. SPY with Trendlines – 1 Minute
    Source: Free Stock Charts


    More trendlines can be drawn when trading in real time, for the varying degrees of each trend. Drawing in more trendlines can provide more signals and also can provide greater insight into the changing market dynamics.

    2. Trade strong stocks in an uptrend, weak stocks in a downtrend
    Most traders will find it beneficial to trade stocks or ETFs that have at least a moderate to high correlation with the S&P 500, Dow or Nasdaq indexes. By trading stocks or ETFs with a high correlation to the major indexes, stocks that are relatively weak or strong, compared to the index, can be isolated. This creates an opportunity for the day trader, as he or she can isolate which stocks are likely to provide a better return, given the movement of individual stocks relative to the index.

    When the indexes/market futures are moving higher, traders should look to buy stocks that are moving up more aggressively than the futures. When the futures pull back, a strong stock will not pull back as much, or may not even pull back at all. These are the stocks to trade in an uptrend, as they lead the market higher and thus provide more profit potential and lower risk; smaller pullbacks mean less risk.

    When the indexes/futures are dropping, short sell stocks that drop more than the market. When the futures move higher within the downtrend, a weak stock will not move up as much, or will not move up at all. Weak stocks are less risky when in a "short" position and provide great profit potential when the market is falling.

    Which stocks and ETFs are stronger or weaker than the market can change daily, although certain sectors may be relatively strong or weak for weeks at a time.

    Figure 2 shows SPY, the S&P 500 ETF, compared to XOP, the Oil Exploration and Production ETF. XOP (blue line) was relatively strong compared to the SPY, especially on market rallies. Overall the market moved higher throughout the day, and because XOP had such large gains on rallies, it was a market leader and outperformed SPY on a relative basis throughout the day.



    Figure 2. SPY vs. XOP – 2 Minute, August 31, 2011
    Source: Free Stock Charts


    3. Be patient - wait for the pullback
    Trendlines help to show how the market moves in waves. Trendlines are an approximate visual guide to where waves in price will begin and end. Therefore, we can use a trendline for early entry into the next price wave in the direction of the trend.

    When entering a long position, buy after the price moves down toward the trendline and then moves back higher. To draw the trend line, a price low and then a higher price low will be needed. The line is drawn connecting these two points and then extended out to the right. Figure 3 shows how XLF, the SPDR Financial Sector ETF, bounced off its trendline twice, providing two potential trade opportunities by being patient and waiting for the pullback in the trendline to occur.




    Figure 3. XLF - 1 Minute Chart, November 4, 2011
    Source: Free Stock Charts


    Short selling in a downtrend would be similar. Wait until the price moves up the downward sloping trendline, then when the stock begins to move back down, this is when the entry is made.

    By being patient, these two long trades provide a very low risk entry, as the purchase is made close to the stop level, which could be several cents below the trendline.

    4. Take profits
    Since markets move in waves, we want to exit before a correction occurs. Day traders have limited time to capture profits and must therefore spend as little time as possible in trades that are losing money or reducing "paper profits" to a substantial degree. When a trade is entered, if it becomes profitable, but the profit is unrealized, it is a called a "paper profit." Day traders want to turn paper profits into real profits before the trend reverses on them.

    There are two very simple rules that can be used to take profits when trading with trends.

    • In an uptrend or long position, take profits at or slightly above the former price high in the current trend.
    • In a downtrend or short position, take profits at or slightly below the former price low in the current trend.

    Figure 4 shows the same XLF chart exemplified earlier. This time entries and exits are marked. The chart shows that as the trend continues higher the price pushes through past highs, which provide an exit for each respective long position taken. Since markets do make double tops, or the price may meet resistance at an old price high, profits can be taken at the same price as the former high, as well. The same method can be applied to downtrends; profits are taken at or slightly below the prior price low in the trend.



    Figure 4. XLF – 1 Minute Chart, November 4, 2011-11-06
    Source: Free Stock Charts


    5. When the market reverses, step aside
    Markets don't always trend. Intra-day trends can also reverse so often that an overriding direction is hard to establish. If major highs and lows are not being made, make sure the intra-day movements, which will be within a range, are large enough for the potential reward to exceed the risk.

    If there are periods where prices move in a horizontal price range, step aside and don’t trade. Alternatively, switch to a range trading type strategy. If switching to a range trading strategy, all the rules still apply. The overall trend does not exist, but is actually a range. Wait for the price to reach near the high of the range and then turn back lower. This will provide a low risk entry and the trade is exited at, or near, the low of the range. The same method can be applied to long entries within a range.

    When low risk entries are not present or clearly visible, step aside and do not trade.

    The Bottom Line
    Day traders should trade with the overall trend and patiently wait for low risk entries to potentially profit from that trend. Trendlines can be used as a guide to help traders determine these low-risk entry points, as well provide potential stop levels. Buying stocks that are stronger than the index in uptrends and shorting stocks that are weaker than the index in downtrends should provide more safety and relative outperformance profits. Profits must be realized and should be taken at or above the prior price high in an uptrend. Conversely, they should be taken at or below the prior price low in a downtrend. Do no trade when the trend is unclear. If a well defined range develops, this may be traded by using a low risk range trading strategy.


    Pattern Day Trading

    An SEC designation for traders who trade the same security four or more times per day (buys and sells) over a five-day period, and for whom same-day trades make up at least 6% of their activity for that period.

    An individual deemed a pattern day trader must hold a minimum of US$25,000 in equity in his or her account before being allowed to day trade. This $25,000 equity amount must be maintained in the account at all times because it addresses the additional risks inherent in leveraged day-trading activities and ensures that customers, before continuing to day trade, cover any losses incurred in their accounts from the previous day.

    Definition of 'Swing Trading'

    A style of trading that attempts to capture gains in a stock within one to four days. Swing traders use technical analysis to look for stocks with short-term price momentum. These traders aren't interested in the fundamental or intrinsic value of stocks, but rather in their price trends and patterns.

    To find situations in which a stock has the extraordinary potential to move in such a short time frame, the trader must act quickly. Therefore, swing trading is mainly used by at-home and day traders. Large institutions trade in sizes too big to move in and out of stocks quickly. The individual trader is able to exploit such short-term stock movements without having to compete with the major traders.

    Definition of 'Wide-Ranging Days'

    A description of the price range of a stock on a particularly volatile day of trading. Wide-ranging days occur when the high and low prices of a stock are much farther apart than they were the day before. Some technical analysts identify these days by using the volatility ratio.

    Wide-ranging days mean the most to traders after a strong day of trading. One of these days after a sharp up- or downtrend can indicate that the trend will reverse. Extreme wide-ranging days generally portend a major reversal.