Alpesh B. Patel on Stock Futures

Alpesh B. Patel on Stock Futures

Alpesh B. Patel on Stock Futures Strategies for profiting from stock futures

HARRIMAN HOUSE LTD 43 Chapel Street Petersfield Hampshire GU32 3DY GREAT BRITAIN Tel: +44 (0)1730 233870 Fax: +44 (0)1730 233880 email: [email protected] website: www.harriman-house.com

First published in Great Britain in 2004 Copyright Harriman House Ltd The right of Alpesh B. Patel and Aranca to be identified as Authors has been asserted in accordance with the Copyright, Design and Patents Act 1988. ISBN 1-8975-9731-2 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publisher. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published without the prior written consent of the Publisher. Printed and bound by Biddles

No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading material in this book can be accepted by the Publisher, by the Authors, or by LIFFE Administration and Management.

About the authors Alpesh B. Patel With one of the largest private investor followings in the industry, Alpesh is a much sought-after speaker on the international circuit, having delivered talks from Guatemala to Spain to China. On Bloomberg TV, a six month analysis of his weekly picks outperformed every other stock picker, analyst, pundit and guru on the channel. His Financial Times column on investing is a must-read for serious traders and beginners alike. As well as writing seven bestselling books on trading, he co-presented the popular ‘CEO in the Hot Seat’ segment on Bloomberg TV. He has also been an invited speaker by Goldman Sachs and American Express on investing. Alpesh placed his first trade at the age of 12 ‘because he lived opposite a post office and they had free bonds leaflets’. He went on to move to privatisation stocks, penny stocks and derivatives by the time he was at university. After qualifying as a barrister, he left the Bar to trade. He is also a regular business commentator on BBC having formerly had two series of his own show on Sky and been hired for three years as Bloomberg TV’s in-house ‘online trading and internet’ specialist. Alpesh has been a regular commentator on stock futures since 2001, making him one of the first and most prolific writers on the subject anywhere in the world. Email: [email protected]

Aranca The author was assisted on this project by Aranca. Aranca is a provider of highend business research, analysis and financial modelling to investment banks, fund managers, stock exchanges and independent research houses. Email: [email protected]

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Dedication To all those who over the years have put their faith in me – I hope you have never been let down: Nigel Bowles Terry O’Shaughnessy Richard Stagg Simon London Katherine Oliver Sir Tim Lankester Alistair Mullis Colin Trenholme Ivan Cleland Lord & Apurv Bagri Rodrigo & Alexandro Botran The team at LIFFE Max Butti, Kaly Thavarajah, Jonathan Seymour Thank you too to Sapna Kandakuri and Davinder Dogra.

Acknowledgements Many thanks to the team at Harriman House, especially of course Philip and Stephen, for the speed with which they have moved on all matters and the efficiency and quality in putting together the whole package. Thanks too go to the team at LIFFE, especially Max and Kaly for their valuable comments on the manuscript.

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Contents Preface

Foreword

Introduction

1

1. Essentials of Stock Futures

What are stock futures? Mechanics of stock futures Data and software

5 14 26

2. Trading Stock Futures

Because you can’t just buy and hold Why 90% of day-traders and futures traders fail What is the essence of profit in the markets? How do you know when to buy and sell? Constructing a stock futures system DIY trading strategy

29 34 37 40 43 56

3. Trading Strategies I – Trading Direction

Trading direction

62

4. Trading Strategies II – Diversification and Hedging

Diversification Hedging

77 81

5. Trading Strategies III – Pairs Trading

Pairs Pairs trading with different currencies Pairs trading: stock vs market performance

83 97 98

6. Risk and Money Management

Introduction Calculating how much to risk Other factors to consider

99 99 104 vii

7. Directory of Stock Futures Resources

Exchanges Brokers Regulators Industry associations Industry information and educational resources Market information Other trading services

125 126 127 128 129 130 130

Appendices

a) Top 15 exchanges worldwide for stock futures trading b) List of USFs traded on LIFFE c) List of SSFs traded on OneChicago d) List of SSFs traded on NQLX e) List of SSFs traded on MEFF f) List of SSFs traded on National Stock Exchange of India g) Sample contract specifications - LIFFE h) Sample contract specifications - OneChicago i) Sample contract specifications - NQLX

132 133 138 141 144 145 147 153 155

Glossary

159

Euronext, LIFFE and Euronext.liffe

173

Index

175

viii

Preface Who this book is for This book is for all stock traders, and some longer-term investors, who are interested in learning about one of the most efficient instruments for short-term trading. No previous experience of futures is assumed, and no great knowledge of mathematics is required. It is hoped that the book will also prove useful to finance students and individuals following a career in finance.

What the book covers The book covers everything you need to know about stock futures. It starts with a basic introduction to futures themselves, as well as advice on the opening and administration of a futures account, then compares stock futures to other trading instruments. The major part of the book describes a range of practical strategies which the stock futures trader can employ to enhance returns and control risk with exposure to the equity markets.

How the book is structured The book is divided into the following main sections: • Essentials of stock futures

This introduces stock futures. What are they? How do they compare with other derivatives? The mechanics of the instrument are then explained, including settlement, margin, transaction costs and pricing. Finally, information and data sources are examined. • Trading stock futures

Why should you trade stock futures? This section explains why short-term trading can be profitable, and why stock futures are a perfect short-term instrument. This section also includes a description of how to build a stock futures trading system.

ix

• Trading strategies

Various strategies are considered to exploit the potential of stock futures. These include trading direction, diversification, and hedging. There is a significant exploration of ‘pairs trading’, for which stock futures are seen as very suitable. • Risk and money management

This chapter answers questions like, “How much of my money should I risk on a single trade?” and “How much money do I need to start stock futures trading?”. • Directory of stock futures resources

A comprehensive guide to online information sources on stock futures. • Appendices

The nine appendices in the book contain a compendium of information about stock futures and exchanges, including sample contract specifications. • Glossary

Finally, the book rounds off with a glossary of important trading terms.

Supporting website

The website supporting this book can be found at: www.harriman-house.com/stockfutures Editorial note

Throughout this book, ‘LIFFE’ is used to refer to the London market of Euronext.liffe. For more about Euronext.liffe, please see page 173.

x

Foreword hen the London International Financial Futures and Options Exchange (LIFFE) launched Universal Stock Futures in 2001 it revolutionised global equity markets by offering a single access point to trade global equities cheaply, easily and efficiently. For the first time, international investors were able to gain exposure to the price movements of global equities on a single exchange, under a single regulatory regime, and without the costs of transacting the underlying equities themselves. USFs provide opportunities to institutional investors and private investors as well. They appeal to different participants for different reasons, but to all they are a simple tool offering flexibility and efficiency. This simplicity and ease of use has generated rapid volume growth in just three years. In 2003 USFs enjoyed record trading volumes with Dutch, German, French, UK, Swiss and Swedish based contracts experiencing a substantial surge of activity. Over six million contracts were traded in 2003 – 60% more than in the previous year – and in June 2003 a record 1.2 million contracts were traded. One of the reasons for the phenomenal success of this product has been the enthusiasm and support of a number of key commentators within the financial community. Alpesh B. Patel was one of the first individuals to recognise the potential of USFs and their benefits for private investors. Alpesh has regularly profiled USFs through his columns and broadcasts, and at trading seminars. This book on single stock futures is not just a compendium of everything an investor needs to know to get the best out of these products; it is also a guide on how to incorporate USFs into specific trading strategies. Alpesh illustrates how they are essentially simple instruments offering multi-dimensional trading opportunities. They can be used for basic trades or for more complex hedging strategies. As with all derivatives products, if used correctly, and with a full understanding of the associated risks and rewards, they are powerful investment tools that can be used to achieve return profiles that normally would not be achievable by using traditional financial instruments. Today, the days of high-price, high-margin exchange trading in an environment of prohibitive taxes and regulation must surely be numbered. Alpesh’s book offers the investor a simple and clear guide to both the rewards and the risks of trading Universal Stock Futures.

W

Hugh Freedberg Chief Executive, Euronext.liffe, London, EC4, July 2004

xi

Introduction “I don’t come to work to earn a living, I come to make money” said David Kyte, one of the legendary futures traders. And that is precisely what the readers of this book should be singularly focused on. I have been trading stock futures for a number of years. Before they were readily available I had for many years eagerly awaited their arrival. The ability to take a position in a falling, as well as rising, market doubles the trading opportunities. Being able to focus on individual stocks opens up even more opportunities. Being able to undertake strategies such as pairs trading allows lower risk trading previously only in the remit of the hedge fund – let alone trading on margin, allowing a more efficient use of trading capital. Financial innovation is at the centre of all financial fortunes, large and small. My aim is to clarify, but not guarantee, the opportunity. I truly believe these are exciting products whose potential remains under-appreciated by private investors. Institutional investors on the other hand are pushing ever-increasing trading volumes in these products which is the key proof of their potential. Perhaps the best way to illustrate not only the interest in stock futures, but in derivatives generally, is to quote from a LIFFE press release:

May 2004 - Euronext key indicators Record May for derivatives Volumes ahead by 20% year-on-year 11 million transactions in cash Over 64 million in the year-to-date Cash products - Amsterdam, Brussels, Lisbon, Paris, 2 June 2004 – 11 million transactions were completed on Euronext’s cash markets in May, bringing the total number of transactions for the first five months of 2004 to 64 million, up 4.4% on the same period in 2003. The activity in May 2004 is 12.8% below the one in May 2003, which was a particularly active month. The average daily number of 612,000 transactions completed since January is up 3.4% compared to the same period of last year. Shares - Share trading showed an increase of 5.1% in the yearto-date, with 61 million transactions registered so far this year, including 10.3 million in the month of May, 492,000 on an average daily basis. Trackers - Transactions in trackers totalled 140,000 since the beginning of the year, representing more than 1,300 per day. 1

Alpesh B. Patel on Stock Futures

Derivatives products - Amsterdam, Brussels, Lisbon, London, Paris, 2 June 2004 - Euronext.liffe, the international derivatives business of Euronext, traded 67.5 million contracts in May 2004, an increase of 20% on May 2003, making it the most active May ever with an average daily volume of 3.5 million contracts. Each month this year Euronext.liffe has broken the previous volume record for that month. Year-to-date Euronext.liffe has traded over contracts, up 29% on the same period in 2003.

371

million

Individual equity products showed the strongest growth, trading over 28 million contracts in May, up 62% on May 2003. Amsterdam set a new open interest record in equity options of 19.8 million on 20 May. Short-term interest rate products traded 24 million contracts during the month and are up 24% year-to-date. Commodities products have also seen continued growth with volumes up 21% year-to-date. Euronext.liffe’s Eurodollar future, launched on 18 March, traded 255,000 contracts in May, with average daily volume rising to over 12,700. Open interest reached 50,000 for the first time just ten weeks after its launch, faster than any other contract in the history of the Euronext.liffe exchanges.

Another LIFFE press release puts the growth behind stock futures even more clearly: Universal Stock Futures Sets New Annual Trading Record by 24 June 2003 LONDON, Tuesday 24 June 2003 – LIFFE’s Universal Stock Futures (USFs) have set a new annual volume trading record, having traded 3,968,230 contracts from January to 23 June 2003 beating last year’s annual record volume of 3,935,121 contracts. June 2003 has been the busiest month ever for USFs. A total of 1,090,462 contracts were traded by 23 June 2003. The previous monthly record of 903,568 contracts was set in April 2003. USFs, which offer futures on underlying blue chip stocks, provide a cheap and efficient alternative to direct cash investing. By allowing investors to gain leveraged exposure to selected stocks for a fraction of the price of direct investment, they are ideal for hedging purposes, and also for portfolio structuring when direct transactions might not be possible for cost or tax reasons. Trading takes place under a single regulatory regime, on a single clearing and settlement system and through a single trading platform, LIFFE CONNECT® . 2

Introduction

Key USF Highlights: • New all-time annual record for all USFs: 3,968,230 contracts traded within the first six months of 2003. Previous annual record of 3,935,121 set in 2002, January to 20 June 2003 is up 196% on the same period in 2002. • New monthly record for all USFs: 1,090,462 contracts traded in June (2 to 23 June). This is the third record-breaking month this year and the first time that monthly volume has risen above 1 million contracts. The previous monthly record of 903,568 was set in April 2003 • German USFs: traded 557,112 contracts January to 20 June, up 158% on same period last year • French USFs: traded 386,387 contracts January to 20 June, up 196% on same period last year • Dutch USFs: traded 1,046,732 contracts January to 20 June, up 1008% on same period last year • Swiss USFs: traded 335,635 contracts January to 20 June, up 637% on same period last year

What is especially fascinating is that the stocks to which stock futures relate are household names. The diagram below shows the top 20 stock futures traded through LIFFE by volume.

So, here we have an ever-popular product. It is based on globally recognised stocks, can be traded ‘long’ and ‘short’ and on margin as well as online through discount commission brokers. I fully expect readers to gain the same passion for them as I have upon completing the book. Happy trading! Alpesh B. Patel [email protected] 3

1

Chapter

Essentials of Stock Futures

What are stock futures? Stock futures are ‘old but new’. Whilst they have been trading on some exchanges for years, in others, especially the key UK and US markets, they are a relatively new invention. • They allow you to trade futures on the movements of major company stock prices. • They are available on the stocks of some of the world’s largest companies in a variety of major currencies: Euro, Sterling, Swiss Franc, Swedish Krona and US Dollar, Danish and Norwegian Krone. • They closely mimic the price of the stock. If Microsoft rises 5%, so will the stock future. Buying a stock future is similar to agreeing to buy shares at a future date, but agreeing the price at the time of trade. The key difference is that stock futures are either cash settled so no shares change hands, or physically settled by delivery of the stock. Conversely, selling a stock future is similar to agreeing to sell shares at a future date (although the seller does not need to own shares to enter into this agreement). As you will see below, there are many reasons for trading the stock future instead of the underlying stock. Although terms like ‘settlement’ and the definition of stock futures might seem complicated, all you need to remember is that you are trying to buy low and sell high and that price depends on the price of the stock – so you have to take a view on the stock.

Definition A stock future is an agreement between a buyer and seller to exchange cash or stock at a fixed future date (the settlement date). 5

Alpesh B. Patel on Stock Futures

A few characteristics of stock futures: • Each futures contract or ‘lot’ represents a certain number of shares depending on the stock. • Futures contracts are listed with a variety of shelf lives – some twelve months, others longer. • There is only ever one contract per stock expiring in a specific calendar month. At the end of the life of the contract you can sell it and roll over to a further out stock future, or take cash settlement or physical delivery. Of course you do not need to hold the stock future to expiry. You can always close the trade sooner. • Trading can be done electronically through online brokers as well as via phone broking.

Attractions of stock futures The key attractions of stock futures are: 1. Capital efficiency

When you trade stock futures, you are not buying the stocks up front, only paying margin which acts as a deposit. For instance, one stock future in Microsoft represents 100 shares, therefore controls a market value of $25 x 100 = $2,500 of Microsoft stock if the stock is trading at $25. But the margin you would have to pay on that would be around 20%, or $500, compared to the $2,500 you would have to pay if you were to buy the stock outright. 2. Investment efficiency

The cash settled aspect of stock futures means that the trader does not have to bear all the costs normally associated with stock settlement transfers. Transaction costs are consequently cheaper. 3. Ease

Depending on which exchange (e.g. LIFFE) you trade through, you will be able to use one account to access some of the world's largest and most popular stocks. There is no need to have multiple accounts with multiple brokers with the complications and inconvenience that that entails. Diversification is therefore easier too. 4. Profit from falls

You can short stock futures – that is, sell them in anticipation of buying them back cheaper in a falling market.

6

Essentials of Stock Futures

A brief history of stock futures Stock futures have been traded for more than a decade now on smaller regional markets. But they have gained greater prominence in the recent past due to new developments. • LIFFE launches USFs in January 2001 One of those developments came in January 2001, when LIFFE launched its programme of USFs (Universal Stock Futures, the name for stock futures traded through LIFFE) covering 25 stocks from a range of countries. At the time of writing there are over 140. • Repeal of the Shad-Johnson Accord In the US stock markets, trading of Security Futures Products (which includes SSFs, Single Stock Futures – the name for stock futures in the US) had been banned for 19 years under the Shad-Johnson Accord. This was because of regulatory concerns, as well as a fear of price manipulation. The Shad-Johnson Accord was repealed in 2000. In December 2000, the Commodity Futures Modernization Act of 2000 (‘CFMA’) gave the Federal Reserve Board authority to promulgate rules governing initial and maintenance customer margin for these newly permissible products. In turn, the Federal Reserve Board delegated its rule-making authority to the Commodity Futures Trading Commission (‘CFTC’) and the Securities and Exchange Commission (‘SEC’). This enabled US investors to trade single stock futures for the first time on regulated US exchanges from December 2001. • NQLX The repeal of the Shad-Johnson Accord led to the formation of NQLX, a market for futures products, which was originally a joint venture between NASDAQ and LIFFE. Trading on this exchange was launched on 8th November 2002. It is now a wholly-owned subsidiary of LIFFE. NQLX was the first US exchange to be approved for the trading of single stock futures – it was in fact created for this very purpose – though it lists other security futures products as well. • OneChicago At the same time, the Chicago Board Options Exchange, the Chicago Board of Trade, and the Chicago Mercantile Exchange joined together to form OneChicago to trade SSFs. OneChicago lists futures on more than 85 wellknown stocks such as IBM, Qualcomm and Microsoft.

7

Alpesh B. Patel on Stock Futures

Rapid international growth

Stock futures now trade on many of the world’s exchanges. A list of the fifteen most active stock futures markets worldwide can be found on page 132. Note, for instance, the position of the Indian stock futures exchange where trading volumes are ever increasing. This international growth has largely been due to London, not, as is often presumed to be the case in financial services, from the US. The latter joined in only after London started the process of internationalising access to stock futures. USFs vs SSFs

At this point it may be useful to explain the (nominal) difference between Universal Stock Futures (USFs) and Single Stock Futures (SSFs). • USFs USFs are traded on LIFFE. They have a heavy European focus with contracts spread across the UK and Continental Europe, but they also include US companies. USFs are currently traded in seven currencies: Euro, Danish Krone, Norwegian Krone, Sterling, Swedish Krona, Swiss Franc and US Dollar. They therefore provide an efficient alternative to trading company shares worldwide. USF contracts are not currently available to US persons. • SSFs SSFs are traded in the US, based primarily on US companies, and available in dollars only. USFs and SSFs are, therefore, essentially the same thing. They are both stock futures – futures contracts on company shares. Security futures

Stock futures are not the only new innovation in the futures market. ‘Security futures’ is the term used to collectively describe futures on individual stocks, narrow-based indices and Exchange Traded Funds (ETFs). These products are now trading in the US. Stock futures are therefore one type of security future. Other security futures include: • Narrow-based index futures These are futures contracts on small groups of stocks that allow an investor to take a position in a concentrated area of the equities market. OneChicago offers futures on Dow Jones MicroSector IndexesSM which each contain five stocks in a focused industry sector such as Aerospace, Banking, Biotechnology and Semiconductors.

8

Essentials of Stock Futures

• ETF Futures Futures contracts on Exchange Traded Funds have similar characteristics to single stock futures, although the underlying security is the fund itself rather than common stock in a specific company. Thus, at expiration, the deliverable assets are shares in the underlying ETF. While we will be focusing primarily on stock futures in this book, the basic structure and mechanics of trading is the same for all security futures.

The jargon Terms you will come across are: • Unit of Trading (in Europe commonly called Contract Size) The number of shares one future normally represents. • Delivery Month (in Europe commonly called Expiry) The date/month when the contract expires and cash or stock must be settled. • Minimum Price Movement The smallest amount by which the future moves. • Tick Value The change in the value of the future for the change in the price. It sounds complicated, but remember most stock futures traders will simply buy and sell and not wait until delivery. They know that a 1p move in a UK stock means a £10 change in a stock future contract based on it. They do not want delivery of the stocks that would occur if they held on to the contract until expiry; they simply want to trade by buying low and selling at a higher price or, if shorting, by selling high and buying back at a lower price.

Comparison with other financial products Of course we want to know why we should pick stock futures to capture a share price move and not, say, another type of derivative like an option. Let us first look at the comparison with spread bets and contracts for differences (CFDs). These two financial products are generally not available to US citizens, whose government does not yet see their citizens fit to trade in these products, so it applies to traders in Europe or Asia. Comparison with spread bets and CFDs

In the table overleaf there is a summary of the key characteristics of stock futures and how they compare with spread bets and CFDs. 9

Alpesh B. Patel on Stock Futures

Table 1.1 – Comparison of stock futures with spread bets and CFDs Characteristic Stock Future

Equity Spread Bet

Equity CFD

Description

Contract where participant gains/ loses difference between opening traded price and final closing price set on a predetermined date.

Bet where participant ‘wins’ or ‘loses’ change in value of shares at a predefined future date.

Contract where participant gains/loses difference in equity value between opening and closing the contract.

Price determination

Standard futures pricing model operated by each market participant - best prices.

Standard futures pricing model used to determine value, but not price. Competition to determine best price.

Traded price equal to prevailing share price. An additional financing cost is imposed on CFD positions.

Liquidity

Competing quotes supported by market makers.

Volume is guaranteed by spread bet firm; exit price is an uncertainty.

Access to market is ‘guaranteed’ by counterparty.

Expiry date

Yes.

Yes.

No.

Settlement style

Cash-settled and physical too.

Cash-settled.

Cash-settled.

Final closing

Determined by the exchange based on underlying share price.

Determined as per terms of the agreement.

No automatic closure - closing established as prevailing share price at closing trade.

10

Essentials of Stock Futures

Comparison with options

The key differences between stock futures and options are: 1.Stock futures tend to rise penny-for-penny with the underlying stock. Options price movements are more complicated, depending on factors such as delta, and time to expiry. 2.You can do many more complicated strategies with options, such as buy the stock and write the option. If you are new to options, don't worry – you do not need to know all these details. Essentially, stock futures are a lot simpler to understand than options. 3.With a long option (where you have bought the option) you know the maximum downside; it is the amount you paid for the option (the premium).

Summary Stock futures have all the attractions of other futures contracts. These include: • Simplicity – Trading futures is very straightforward (unlike, say, options), and once you understand futures in one market, you pretty much understand them in every market. • Diversification – From one futures account you can trade many different markets. • Pricing transparency – Futures contracts are traded on an open, competitive market, where all participants see the same prices. • Low transaction costs – This is probably the most important factor for traders. Assuming reasonable liquidity, transaction costs will normally be lower in futures markets than other associated markets. This is why futures are the instrument of choice for most active traders. (Admittedly, ‘reasonable liquidity’ is a big assumption, as liquidity cannot be guaranteed for all futures markets.) • Advanced trading platform – Futures trading platforms (order entry and execution) are now very sophisticated. • Exchange-regulated – Ensuring a fair market, with a measure of protection if things go wrong.

11

Alpesh B. Patel on Stock Futures

Are stock futures right for you? Day job

This is simple. If you have a day job, you cannot day-trade stock futures. Daytrading requires your total attention in front of a PC. There are those who may start work late or finish early who may be able to squeeze in some trading, but I do not recommend such an approach. Your best option if you have a day job but you still want to trade stock futures is the short-term trade where you hold a position for a few days and monitor it occasionally with a call to your broker or a quick view of the web at work. The lifestyle you want to lead

If you are day-trading stock futures then the chances are you are going to spend at least a couple of exhausting hours in front of the PC every day. Some days you may be there from before the markets open until they close. On the other hand, if you are trading so as to make your profits from holding positions for a few days, then you will do most of your analysis each night after the close of trading and after you have updated that day’s end-of-day price data. I trade both intra-day (futures) and also short-term (in stocks and options). I trade a couple of hours in the morning or afternoon (rarely both, because I just get too exhausted), and then for my trading where I would be looking to hold positions for a few days I will do the analysis in the evening. That leaves me time to do other things in the day. It is simply a personal choice. Your personal choice may be to day-trade all day, then analyse all evening. I prefer a more balanced life with different activities – even if they are trading related. So these types of lifestyle issues will also have to be added to the cauldron in which your choices are stewing when you decide what time-frame you want to trade within.

A day in the life of . . . To give you an even better idea of how short-term stock futures traders’ days are spent, read through the example of a trading session opposite. I do not want you to be under any misapprehension about the risks of short-term trading or the difficulties you need to overcome. I want you to have an appreciation of why your successful short-term online trading compatriots have chosen the time-frame they have. This should avoid any superficial and misleading attractions to this form of trading, which can lead to substantial losses. 12

Essentials of Stock Futures

The day-trader in Microsoft stock futures

08h 00 08h 05 08h 20

08h 30 10h 00 10h 15 10h 30 10h 40 10h 41 10h 42 10h 45 10h 50 11h 00 11h 02

11h 05 11h 15 11h 16 11h 17 11h 18 11h 19

At desk, make sure computer up and running, data being collected. Go through latest headlines on financial websites to check what has happened overnight. Make a note of likely pivot points and supports and resistances for the day based on past week’s action and yesterday’s action. Monitor market but, as per system, do not enter before 10:00. View momentum indicators on 3 minute and 5 minute bar charts of likely buy or short signals. Possible buy signal. Ready to click on buy, wait. No, false alarm. Still no signal, continue watching. Possible signal to short. Confirmed. Click on sell and enter order. 5 sold. Make note of stop loss (and print out price chart). While monitoring prices, draw on price chart possible target levels, supports and resistances. Price rises. Doubts creeping in. Price hits within points of stop loss. Indicators still suggest holding position. Position still open. Price now running up quickly, indicators not showing sell, with paper profits eroded. Trailing stop near, get ready to close. Price continues dropping. Price starts rising. Momentum on 3 minute chart suggests exit. Momentum on 3 and 5 minute suggest exit, MACD (Moving Average Convergence Divergence, a charting indicator which generates buy and sell signals – more on this later) still suggest in. Trailing stop hit. Exit. Hit sell order, wait for fill price: 5 bought and position closed. Reconfigure for next trade. Return to screen. 13

Alpesh B. Patel on Stock Futures

Mechanics of stock futures Quick revision of futures basics Time for some basics. Old hands can skip this part if they wish. Just as with stocks, although you do not need to know the intricacies to trade profitably, it is useful to know. What are futures contracts?

A futures contract is an agreement between a buyer and a seller to trade a particular asset (e.g. shares) some time in the future at a price agreed today. Futures contracts may be cash-settled or require physical delivery of the underlying asset, i.e. the parties may agree to deliver the equivalent cash or the actual stock instead. They are called derivatives because they derive from an underlying stock or other asset. Futures contracts are bought and sold on regulated exchanges like LIFFE in London. Such exchanges are the equivalent for derivatives of the New York Stock Exchange (‘NYSE’) or the London Stock Exchange for stocks. Thus stock futures are contracts to buy or sell shares (or the equivalent in cash in the case of cash-settled stock futures) at a predetermined price and a predetermined date in the future. Calculating the profit/loss on stock futures trades

If you sell a futures contract at a higher price than you bought it, you’ll make money. If you sell it for less than you bought it, you’ll lose money. It doesn’t matter whether you first went long or short. The formula is the same: Profit = (Price sold - Price paid) x (Contract size) x Number of contracts The mechanics of trading stock futures are fairly straightforward. If you believe that the price of a particular stock will:

↑ Rise

↓ Fall

Buy, or go long the stock futures contract

Sell, or go short the stock futures contract that you don’t own

In futures trading, you don’t have to wait for an uptick as you might have to when shorting stocks, so going short is as easy as going long. 14

Essentials of Stock Futures

Assume, for example, that you bought one April futures contract on XYZ Company at a price of $50 during the first week of February. This gives you the obligation to buy 100 XYZ at $50 per share if you are still long the contract when it expires. You can end your agreement to buy XYZ by selling the April futures contract (‘closing it out’) at any time on or before the contract’s last trading day, the third Friday in April. If XYZ’s price at the time is greater than $50, you make $100 for each dollar it is higher, and you lose $100 for each dollar it is lower. The procedure for selling short is just the opposite. You can offset your obligation at any time on a short contract by buying it back (closing it out) before you would need to deliver XYZ shares. If XYZ’s price at the time is less than $50, you'll make $100 for each dollar it’s lower, and you’ll lose $100 for each dollar it’s higher. Examples – profit/loss on a futures trade

Let’s say you go long (i.e. buy) 5 XYZ futures contracts at $50 each. If you sell them later at $55 each, your profit is $2,500, calculated as ($55 - $50) x 100 shares x 5. If, however, you sell them at $45, your loss is -$2,500, calculated as ($45 - $50) x 100 shares x 5. More examples: -----------------------------------------------------------------------------------------------You go short at $48, and close the position at $52 Initial margin*: (20% x $48) x 100 shares x 5 contracts = $4,800 P/L: -$2,000 Return on margin: -$2,000 / $4,800 = -41.6% -----------------------------------------------------------------------------------------------You go short at $48 and close the position at $44: Initial margin: (20% x $48) x 100 shares x 5 contracts = $4,800 P/L: $2,000 Return on margin: $2,000 / $4,800 = 41.6% -----------------------------------------------------------------------------------------------You go short at $50 and close the position at $45: Initial margin: (20% x $50) x 100 shares x 5 contracts = $5,000 P/L: $2,500 Return on margin: $2,500 / $5,000 = 50.0% ------------------------------------------------------------------------------------------------

* We will discuss Initial Margin in more detail later, but for the time being think of it as a goodwill deposit required by your broker to ensure that you have cash upfront, and that they are not left out of pocket if the market moves against you.

15

Alpesh B. Patel on Stock Futures

Transaction costs Transaction costs are the friction in trading. Many theoretically profitable trading systems are loss-making after transaction costs are taken into account. A number of components make up the cost of a transaction – for example, broker commissions, liquidity (as reflected in the bid-ask spread), and slippage (the difference between the price when an order is given, and the actual executed price). Commissions

Most of the examples in this book do not include commissions paid to your broker. As in stock trading, the cost of commissions is subtracted from your profits to determine your net profit or added to your losses to determine your total loss. You should also be aware that futures brokers may calculate commissions on a round-turn basis – that is, commission covers both the cost of opening and closing a position. Stock commissions are typically calculated separately for each side of a transaction. Commissions can be very low indeed compared to the same level transaction in equities. They vary and are coming down monthly so do check with brokers for the latest rates. Liquidity

The margin system allows traders to transact a very large volume of securities for a relatively small capital outlay. It requires traders to put up only a part of the value of the underlying securities covered by the contract (mostly between 10% and 20%), rather than their full value. This leverage attracts more trading into the market, which in turn leads to better price discovery and generates liquidity. By liquidity we mean the volume of trades, a useful measure of interest in the product. The liquidity has benefits. If there is a lot of volume, price spreads (the difference between buy and sell price) tend to be narrow, and the instrument tends not to get short sharp shocks from big surprise orders. As far as the liquidity of the instrument itself is concerned, a stock future should be as liquid as the underlying stock, theoretically speaking. However, this is not the case in practice because of hedging and position funding costs. As a result, spreads on stock futures can be wider than the spreads on the underlying stock. Bid-ask spread

The bid-ask spread is a major concern for traders in stock futures. Their fear is that if the product does not have a big take-up, the volume (and thereby liquidity) will be low, and the bid-ask spreads will be wide, and so a hidden cost of trading will be incurred. 16

Essentials of Stock Futures

The exchanges through which stock futures are traded – LIFFE, NQLX, OneChicago – are all aware of this and have made efforts to reduce spreads. 1.There are restrictions on market makers (the firms which are obliged to quote bid-ask prices so people can get in and out) on how wide spreads can be. Second, to the extent this leveraged product is a substitute for other leveraged products like options, then traders are not as dispersed because for each security there are not, of course, multiple strike prices as there are with options. 2.The exchanges have been keen to ensure they list stock futures on the most liquid stocks, such as Microsoft. A quote from a trader whose early impressions of the market are positive: “So far, so good. From a trading standpoint, there are a couple of reasons I am optimistic about this new market. First I give NQLX a thumbs-up on their platform. Looking at pure performance and reliability, I'm very impressed and I've found it very usable.” This trader’s comments mirror others I've heard regarding the markets’ liquidity: “There is a lot more liquidity than meets the eye. The bid-ask on Microsoft is usually 2-5 cents, at times maybe even a penny. Then every two pennies up and two pennies down, there might be another bid or offer. The size might be showing only 20 on the screen. If I want to sell 1,000, there is a market maker willing to pay 2 for 1,000, but he doesn't show it all at once.You can't judge the market just by looking at the book. A few months down the road, I wouldn't be surprised if I were trading 2,000 to 3,000 SSFs a day.” Stocks Futures & Options magazine, February 2003

Price For people new to trading futures (or derivatives in general) it can be difficult to understand what actually controls the price of the future, and how it relates to the underlying asset (in this case a share price). In general, the price of the future will follow the price of the underlying share. If the underlying share rises 10%, then – give or take a very small difference – the associated future will also increase 10%. However, stock futures do trade in a different market from the underlying share market, and the futures are subjected to the normal forces of supply and demand in their market, as much as the shares are in the equity market. As such, it is common to see the futures price fluctuating around the price of the underlying share – sometimes it may be a bit more than the share price, sometimes a bit less. Like a moth near a light bulb, the futures will occasionally move slightly away from the share price, but will always be attracted back to it. 17

Alpesh B. Patel on Stock Futures

Arbitrage keeps the futures and share prices in line

Why is the future ‘attracted’ to the share? What is this force of attraction? The answer is arbitrage. If the futures price deviates too far from the underlying share price, arbitrageurs come into the market and exploit the mis-pricing opportunity. Their arbitrage trades will force the futures and share prices back into alignment. For example, if the futures price rises too far away from the share price, arbitrageurs will sell the futures (eventually forcing the price down), and buy the underlying shares (eventually forcing the share price up). This will continue until the futures and share prices come back into alignment (when arbitrage will no longer be profitable). The ‘theoretical price’ of stock futures

If you have $10,000 and think a company’s shares are set to rise in the next two months you have a choice of two instruments to trade: shares in the company, or the associated stock futures. Your profit/loss in the trade will be determined by: 1.Shares: The capital appreciation in the shares, plus any dividends accruing over the trade period. 2.Futures: Capital appreciation, plus any interest payable on the cash over the trade period. Assume for the moment that the price of the shares and futures are the same at the time of the trade. If held to expiry of the futures, the capital appreciation on the shares and futures would then be identical. But the dividend and interest payment would likely be different. If interest payments were greater than the dividends payable, then a rational investor would prefer to own the futures: the capital appreciation would be identical, but the interest payment on his cash would be greater than the dividends he would receive by holding the shares. Alternatively, a trader could buy the futures and short the shares, and make a risk-free profit. And this is exactly what does happen in the market when such opportunities present themselves. In the case here, the futures would be bought (thus increasing their price), and the share sold (decreasing the price), the net result being to widen the gap between the futures and share prices until a point when no further arbitrage was possible. This would be when the higher futures price effectively negates the difference between interest and dividend payments. And this price of the futures is called its ‘theoretical price’ (or equally, the ‘fair price’). It’s the price at which no arbitrage is possible, because the price takes into account all differences in cash flows for futures and shares. An alternative way of expressing this is that the futures price should equal the cost of buying the shares and holding them until the expiry of the futures contract. 18

Essentials of Stock Futures

Assessing the total cost of buying stock and holding it until the expiry of the future may seem difficult to anticipate, but it is really made up of three main elements: 1.The price of the underlying stock 2.Any interest income foregone by holding shares rather than cash 3.Any dividends paid to the holder of the stock before the expiry of the future Expressing this as a formula, we have: Fair futures price = Today's share price + Interest costs - Dividends received Futures typically trade at a premium to the stock price because of an adjustment for interest rates (and interest rates being typically higher then dividend yields). Although when a large dividend payment is forthcoming, or if the underlying stock is difficult to borrow, the futures price may trade at a discount or premium to the actual cash price. Revised futures/share price relationship

With this knowledge of a fair futures price, we need to slightly revise the description of the relationship between the futures and share price given above. Before we said that the futures price closely follows the underlying share price. A stricter definition would be that the actual traded futures price closely follows the fair value from the futures (where the fair value is a function of the share price and the differential in interest rates and dividends – sometimes called the ‘cost of carry’). If the futures price does deviate sufficiently far from its fair value, this attracts arbitrageurs whose actions bring the two back into alignment. Finally (and because nothing is ever truly simple in the financial markets!), a future’s fair value is not necessarily the same for everyone. While all shareholders receive the same dividend per share, not everyone’s risk-free rate is the same. For example, a bank would have a different funding rate than a small individual trader. Because of this, the fair value for a bank would be different from that of the individual trader.

Summary We’ve gone into some detail on fair value and arbitrage. Don’t worry if you didn’t follow all of it. The key point is that futures pretty much follow the underlying shares. The three lessons to learn from this are: 1.The actions of arbitrage ensure that the futures perform in line with the shares. 2.The minute details of fair value are, broadly, of more concern to hedgers and arbitrageurs than they are to speculators. 3.The price will be identical at expiry to the underlying share price. 19

Alpesh B. Patel on Stock Futures

Settlement When a contract expires there are two types of settlement possible: • Physical delivery

In this case the seller of the contract delivers actual shares, and the buyer of the contract takes receipt of actual shares. So, in the case of a Microsoft SSF, when one contract expires, 100 shares are delivered by the seller of the contract, and 100 shares are received by the buyer and you pay in full for the delivery. • Cash settlement

In the case of cash settlement there is a simple cash payment that reflects the change in share price, and mimics to all intents and purposes the economic impact of the trade. So, a cash-settled contract requires a cash amount to be paid at the end of settlement day, reflecting the difference between the futures price and the price of the underlying share. The latter, the price of the underlying share on settlement day, is also known as the settlement price. Different exchanges list contracts with either physical or cash settlement. It is wise to check the contract specifications before trading any contract, although, for a speculator, the difference between the two types of settlement is rather academic. The great majority of stock futures contracts are cash-settled. LIFFE listed physically-delivered Universal Stock Futures (P-USF) contracts on 21st November 2002. P-USF contracts are similar to the existing Universal Stock Futures contracts, but are physically delivered rather than cash-settled. PUSF contracts are available on shares in Euro, Danish Krone and Norwegian Krone. At maturity the holder of a long P-USF contract position will receive a number of shares of the underlying equivalent to the number of contracts in the position multiplied by the size of the contract. Conversely, the holder of a short P-USF contract position will have to deliver a number of shares of the underlying equivalent to the number of contracts in the position multiplied by the size of the contract. Most positions offset before expiry Traders new to futures can sometimes become confused, and worried, over the issue of settlement. However they need not be, as the vast majority of futures positions are closed out before expiry, and thus never reach settlement. A trader might go long of a contract one day at price 57, and sell it the next day (effectively closing the position) at 60. That trader is unconcerned about how the contract might be settled. It is academic. All that concerns him is that he made 3 points on the trade. 20

Essentials of Stock Futures

In some futures markets, well over 90% of all futures positions are closed out before reaching expiry. This is certainly the case for speculative positions. Arbitrage positions may be held to expiry. So, while it never hurts to know the specifications of the contracts you trade, it’s not necessary to worry too much over the detail of settlement.

Contract expiries At any one time, each stock (with stock futures) will usually have three or four different futures contracts associated with it. These contracts will be identical except for the expiration dates. The actual expiration dates, and cycle of expiration months is fixed and determined by each futures exchange. For example, the contract specifications of LIFFE’s USF contract state: Delivery months Nearest two of March, June, September, December, plus nearest two serial months such that the nearest three calendar months are always available for trading.

So, in January the contracts for trading would be: January, February, March, and June. And prices for these contracts might be quoted as shown in the table below: Table 1.2 – A typical price chart for a stock future

Stock January future February future March future June future

Bid

Offer

50.00 50.19 49.99 50.19 50.80

50.05 50.25 50.05 50.26 50.87

When the January contract expires, a new contract (April) would be listed for trading. Contract liquidity

Although four contracts may be listed, normally one would find the greatest trading volume concentrated in the near month (the contract closest to expiry). Therefore this is where the keenest prices would be. However, due to the ease of hedging, market makers would still be making bid-offer prices in the other contracts. 21

Alpesh B. Patel on Stock Futures

‘Last trading day’

Each exchange will define exactly when its contracts expire. And, like most of the other details, this information can be found in the contract specifications. In the case of the USFs listed on LIFFE, the last trading day of the contract is defined as: Last Trading Day Third Friday of the delivery month Managing expiration dates

There are three basic approaches for managing the expiration of futures contracts. 1. Closing (offsetting) the position Prior to expiration, you may offset your trade by covering (buying back) a short position or selling a long position. You don’t have to wait until the expiration date to complete your trade. Many investors choose to offset equity futures positions before expiration. A trader might, for example, take a long position of two contracts of XYZ company (equal to 200 shares) that expire in December. To offset the position, he would subsequently sell two contracts of XYZ with the same expiration month. He could just as easily take an initial short position by selling two December XYZ contracts and then offset it by buying two contracts of December XYZ. Note: when giving the order to close the position, the trader should inform his broker this is what he is doing. This would avoid opening a new position. 2. Taking delivery You could wait until the contract expires, then make or take delivery. On the expiration date, holders of short positions of physically-settled stock futures are required to deliver physical shares of the underlying security, and holders of long positions take delivery of the underlying security. This means that buying a stock future and holding it until expiration guarantees your ownership of the underlying security after the expiration date. If you offset your position, this process does not apply. If you are considering holding a security futures contract until expiration, consult your brokerage firm regarding its procedures and fees associated with delivery. 3. Rolling over As we’ve seen, each contract series (the set of stock futures associated with a particular stock) may contain three or four contracts, each with a different expiry date. But these contracts are all fairly short-term. 22

Essentials of Stock Futures

So what does a trader do if he wants to take a position for a longer time than six months? Or only wants to trade the liquid near month but has a three month view on the market? The answer is what’s called rolling over of the contracts. If you hold a long position in an expiration month, you can simultaneously sell that expiration month and buy the next expiration month for an agreed-upon price differential. Thus the position is transferred, or rolled forward, and can be held for a longer period.

Margining To protect the interests of all parties involved in futures transactions, a risk management system – a margining system – is employed by the clearing house. The clearing house associated with a futures exchange acts as the central counterparty to all transactions. In contrast to stock trades, margins do not represent a down payment in futures transactions; they represent a promise to fulfill the terms of the contract, should the need arise. There are two major types of margin – ‘initial’ and ‘variation’. • Initial margin is a deposit required on all positions and is returned by the clearing house when positions are closed. It is also known as performance bond, and protects the clearing house from any adverse price movements in the event of a clearing member defaulting. • Variation margin reflects the change in value of a portfolio of contracts and is calculated and paid daily. If the market does not go in the investor’s favour, additional margin – a maintenance margin call – is to be posted to ensure that the promise is still intact. Generally, margin is based on the volatility of the market. Rapidly moving markets normally have higher margins, and slower markets normally have lower margins. The system of margin is one of the prime factors that makes stock futures (and futures in general) interesting. They can be used to leverage an investment – as seen in the example over the page. For an example of typical margins from a typical broker, read the text below in conjunction with the table overleaf. “To open a new position, you are required to have a minimum of $2,000 or US dollar equivalent in your account. Note: The following makes use of the function "Maximum (x, y, ..)". The Maximum function returns the greatest value of all parameters separated by commas within the parenthesis. As an example, ‘Maximum (500, 2000, 1500)’ would return the value 2000. Margin requirements quoted in US dollars may also be satisfied with a nonUS dollar equivalent.” 23

Alpesh B. Patel on Stock Futures

Stock Future

Initial and Maintenance

Long or Short SSF

20% x SSF market value

Long SSF and Short SSF with different expiration dates (same or different exchanges)

Maximum (5% long SSF market value), (5% x short SSF market value)

Long SSF and Short SSF with same expiration date (different exchanges)

Maximum (3% long SSF market value), (3% x short SSF market value)

Example of a stock trade vs a USF trade on LIFFE

Stock A is currently priced at $10.00, and its December future is priced at $10.20. To buy the stock, the full $10 must be paid to the seller. To buy the future, $1.10 multiplied by the contract size must be deposited with the clearing house. A few days later, the stock price has risen to $11.00 and the future has risen to $11.20. The respective returns would be as follows:

Opening price Closing price Net gain Initial investment Return on investment

Stock ($)

USF ($)

10.00 11.00 1.00 10.00 10%

10.20 11.20 1.00 1.10 90.9%

Thus there is a greater return on investment in the stock future, because only a fraction of the amount required to buy the underlying shares has to be paid upfront. The SPAN system of margining

SPAN stands for the Standard Portfolio Analysis of Risk System, which the Chicago Mercantile Exchange developed in 1988. With CFTC approval, SPAN has been available in the US to calculate customer and clearing house margins for futures and options. Since the introduction of USFs, LIFFE and the London Clearing House have applied the SPAN portfolio-margining system, which has long been used in US futures markets for calculating initial and maintenance margin for customers. 24

Essentials of Stock Futures

To make matters easier it is possible to get ‘margin offset’ because SPAN would calculate the positive margin needed for one position, offset against the negative of another. So the aggregate margin is not necessarily the sum of the margins on each individual position. Portfolio-based margining provides a means to preserve the financial integrity of the marketplace, while at the same time controlling systemic risk. Unlike strategy-based margining, which does not take price volatility into account, portfolio-based margining sets customer margin levels on the basis of the historical price volatility of the instrument, as well as on the current net exposure of a portfolio of related positions. Example – margining on stock futures

Let us say you have $16,000 you want to trade in a stock future in Vodafone. That equates to £10,000. The stock is trading at 100p. You think it is likely to fall. So you sell 10 Vodafone stock futures. The margin required by the broker will only be around £1,500. So the remaining £8,500 can be kept in a bank account earning interest. As the price of the stock falls, so does the stock future. If you then buy back the stock future to close the trade when the stock future is at 90p, then since one stock future on a UK stock represents 1,000 shares, that is a £100 profit (1,000 x 10p x 1 contract). Across 10 contracts it is a £1,000 or $1,600 profit.

Dividends When you buy ordinary shares in a quoted company you generally acquire rights to dividend payments and the right to vote on company matters. When you buy a future on the stock of the same company, you do not get dividends or voting rights. This is logical as the purpose of buying a future is not the same as that of buying the underlying stock. A stock is bought with an intention to invest in a company and get involved with it. A future is bought with a short-term intent – to speculate, to hedge. The difference is reflected in the price of the stock future. The more valuable the dividend being paid on the stock, the lower the price of the future. The buyer is paying less for the future and so is compensated for the dividend he misses. The futures seller is happy to sell at the lower price because he does not have to pay the dividend to the buyer. The prices of stock futures are adjusted not only for dividends, but also for other ‘corporate actions’. Overleaf, some of these corporate actions are described, and their effect on stock futures pricing noted. 25

Alpesh B. Patel on Stock Futures

Corporate actions Corporate actions can change the financial structure of a company. Such measures include stock splits, stock consolidation, special dividends, and spin-offs. • Stock splits: The division of shares into a larger number of smaller units, e.g. a 2-for-1 stock split would create twice the number of shares worth half the price. • Reverse splits: A reverse split creates a smaller number of larger units. • Rights issues: A grant by the issuing company to existing shareholders of the right to buy additional shares, in quantities proportional to current ownership, before they are offered to the general public. Stock futures exchanges take account of all these corporate actions, and changes are made to the stock futures to reflect any corporate action taken by the underlying company.

Data and software Daily data requirements Trading is all about price. So you need price data for the markets you are trading. The cost and availability of data can be a determining influence on the trading method you choose. For intra-day trading you need real-time, tick-by-tick data. Don’t even think about following positions using delayed quotes or the occasional call to your broker. Always keep an eye on your position. Only novices place a position then do not keep an eye on it and forget about it. Real-time, tick-by-tick data is more expensive than end-of-day data. Indeed endof-day charts are available for free on many websites which also permit you to do technical analysis. (Some of the best sites are listed later.)

Historical data requirements With end-of-day data you need not only the daily updates, of course, but also price history with which to test your trading system ideas. Price history is also available relatively inexpensively from specialist websites. Again, the best ones are compatible with most of the top software programmes listed opposite. The technical analysis websites listed later also provide historical price charts, for free of course. With real-time data it is often impossible or prohibitively expensive to obtain historical tick-by-tick data. The usual practice is to build an historical database as you go along by collecting and storing real-time data. At www.liffe-style.com you will find a variety of historical data. 26

Essentials of Stock Futures

Product

Company

Address

Ranking

Cost

MetaStock 6.5

Equis

www.equis.com

***

$349

Omnitrader 3.1

Nirvana

www.nirv.com

***

$395

SuperCharts

Omega

www.omegaresearch.com

**

$200

TeleCharts 2000

Worden Bros

www.worden.com

**

$29

TradeStation

Omega

www.omegaresearch.com

**

$200

Window on Wall Street

Window on Wall Street

www.wallstreet.net

**

$295

*** = recommended

Software requirements Having data is one thing; you also need some way of displaying it. Here you have two choices. You can either view it on the website itself using your web browser (i.e. no specialist software required) or you can view it on your PC using special software (again the top providers are reviewed and listed later). I prefer viewing things on my PC using software, rather than on a website, because website charts, though cheaper than software, are always more limited in what they can do. The longer the time-frame you trade, the less need you will have for specialist software, and therefore the lower your potential costs. That is one reason many short-term online traders start out holding positions over a number of days, not intra-day over a number of minutes. If you are placing trades which you expect to hold for several days, you can get by using the online charts available on sites such as www.equis.com.

27

2

Chapter

• • • •

Trading Stock Futures

How do you know when a stock future is about to rise or fall? How do professionals plan trades?

What types of trading systems are there?

What does a profitable strategy look like?

Because you can't just buy and hold Stock futures are attractive precisely because ‘buy-and-hold’ strategies in shares take so long to give any returns at all. In trading stock futures we are of course trying to capture the big rise days and be out of the market when the odds of falls are increased. Look at the two charts below. Essentially the stock futures trader is trying to be long stocks on the right-hand side of the graph, and short stocks when returns are on the left-hand (falling returns) side. Figure 2.1 – Distribution of daily S&P returns 1998-2000

29

Alpesh B. Patel on Stock Futures

Figure 2.2 – Distribution of monthly S&P returns 1926-2001

Yes, we are trying to time the market In this book we examine tools that allow professional traders and private investors to time the market. We are trying to time the market because we know that we must be in a position to react to market news and not simply sit back and do nothing. The table below shows how markets have reacted in the past to major news stories. A stock futures trader will go long or short based on marketmoving news. He will not just sit back and do nothing. Consequently in this book we examine some good ways to get news and therefore be able to take stock futures positions accordingly. Table 2.1 – Dow Jones Industrial Average reaction to news events Date

Event

Subsequent market reaction % 1 day 1 month 6 months

17 Jan 1991

US launches attack on Iraq

02 Aug 1990 30 Mar 1981

4.60

11.80

Iraq invades Kuwait

-1.20

-8.80

-3.20

5.00

President Reagan shot

-0.30

0.60

-14.30

-16.90

09 Aug 1974

President Nixon resigns

-0.97

-14.70

-8.90

6.00

22 Nov 1963

J.F. Kennedy assassinated

-2.90

6.60

15.40

25.00

22 Oct 1962

Cuban Missile Crisis

-1.90

15.60

27.40

34.00

26 Sep 1955

Pres. Eisenhower heart attack

-6.50

0.04

12.50

5.70

25 Jun 1950

N. Korea invades S. Korea

-4.70

-4.50

7.40

15.10

07 Dec 1941

Pearl Harbor attack

-3.50

-0.90

-6.20

2.90

30

15.00

1 year 24.50

Source: dowjones.com

Trading Stock Futures

Over what time-frame should you trade stock futures? Day-trading and short-term trading: the choices we make, and the lives we lead. A very important aspect of trading success is that you understand whether you want to trade short-term (for a few days at a time), or day-trade, and why. The most frightening phenomenon is of people thinking that day-trading is a ‘get-rich-quick’ scheme. It is almost as if they think the shorter the time-frame they trade, the more money they can make. It is a recipe for disaster if ignorance and greed overcome diligent hard work. Table 2.2 – Comparison of day-trading and short-term trading Factor

Day-trading

Short-term trading

Holding period

Intra-day. No overnight positions.

Typically a few days to a couple of weeks.

How profits are made

A large sum of money trading on a small price move. Leverage to produce gain from a relatively small price move.

A medium sum of money making a gain from a medium-sized price move.

Monitoring time commitment

Trader in front of screen taking advantage of quick price moves.

Since price move typically develops over a number of days, can check position every few hours.

Research time commitment (i.e. after market hours)

Nightly research not strictly necessary.

Nightly updating of price charts and analysis to find new trading opportunities.

Trader characteristics

Intense concentration. Decisiveness. Calmness under pressure.

More premeditated, thoughtful and relaxed.

Examples

Level II Nasdaq trader on earnings 'pops'.

Swing trader, momentum trader.

You can make money trading short-term, but not because it is a secret short-cut to riches. If you make money, it will be because you have applied a special set of skills. 31

Alpesh B. Patel on Stock Futures

Characteristics of day-trading and ‘days’-trading What does a stock futures trader need to know when deciding how short a timeframe to trade? Once you have decided not to be a long-term investor, you still need to decide how short your short-term trading is going to be. You could trade by the minute or you could hold positions for a few days. Whatever you decide, it should be a conscious decision, not something you fall into. Below are the factors to bear in mind when making the choice. Analysis methods you prefer

One of the factors affecting your choice of time-frame should be the form of analysis you would have to conduct in order to be profitable trading that timeframe. You must ensure you are comfortable with it. For most stock futures traders this means trying out the different ways and seeing which fits best, or reading about them and taking a calculated guess at which they think, given what they know about themselves, they will like best.

Techno-fundamentalists Profile Requirements

Combine technical analysis (‘TA’) and fundamental analysis. These traders want the best of both worlds. They usually pay equal attention to both types of analysis and are usually short to medium-term traders (two weeks up to nine months between buying and selling).

Short cutters & Pure Technical Analysts (‘TAs’) Profile

Requirements

32

“I can't be bothered reading all this fundamental analysis” – this type of trader uses technical analysis solely. He may have rationalised why, or may just be lazy. Technical analysis, being graphical, is easier to grasp and assimilate than fundamental analysis which requires some understanding of company accounts. Sometimes these traders’ time-frames can be over one year, but it is generally rare to be a long-term investor based solely on technicals because the general perception is that technical systems work best over shorter periods and fundamentals over longer, although the interaction between the two can be subtle and complex.

Trading Stock Futures

Day-Traders / Frequent Traders Profile

Almost certainly technicians, including those who just look at price moves and order-flow. A few look to buy on the release of fundamental data (e.g. profits greater than expected) to sell a few days later.

Fundamental Investors Profile

Requirements

The pure fundamental trader will consider charts to be nonsense. Most are willing to examine them and may supplement their fundamental analysis with some technical analysis. Intermittent use of charting, interest in charting fundamental data (P/E ratios, news flow). Charting of fundamental data i.e. a graphical depiction of information is innovative. I have yet to see it even on the best US sites. I think most site designers have simply not considered the potential of providing traditionally textual material in a visually appealing and readily digestible format because they have not understood the mind of a trader/investor. Fundamental traders will often have a medium to longterm (buy-and-hold) interest. However, although most long-term investors find technical analysis of little use, it can be used in the short-term by them to determine the precise entry point. That is something few realise because they lack professional training or experience.

Novice Investors Profile

Requirements

New to trading. Tend to know more about fundamentals than technicals simply because more people talk about it. Technical analysis because of its potential simplicity, i.e. finding correlation between prices and other indicators and trading off that can seduce more new traders and investors than can fundamentals with its focus on heavy reading, accounts and the like.

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Alpesh B. Patel on Stock Futures

Most successful short-term stock futures traders will not be doing it simply for the money. They are doing it because they believe in the method of analysis they are using. For instance, if they are using technical analysis, they do believe in it. If you think trading short-term is a short-cut to riches, and have no interest in analysis or belief in the theory, you could lose a lot of money. You cannot deceive the market, it will see through you. So if you are going to trade short-term you are going to note that the types of strategies in this book involve either technical analysis of charts, tape reading, or monitoring quotes. Occasionally you may be buying on a news item such as analysts’ downgrade or earnings surprise. Whichever of the strategies you choose, you must make sure it makes sense to you, and not choose it because you think it contains some secret formula or recipe for riches. Additionally you will have to satisfy yourself you can skillfully practice the skills needed to execute the strategies. For instance, day-trading stock futures using real-time, tick-by-tick data requires quickness of mind, intense concentration and a decisive mind. If you don’t have those attributes, you shouldn’t do it. Only you can make that judgement. You may feel, on reflection, that a slightly longer time-frame suits you better.

Why 90% of day-traders and futures traders fail Popular wisdom has it that 90% of short-term traders in stocks and futures fail. Whether the actual figure is correct, it is certainly high enough to make you think twice about the whole thing. And so it should. But what apprehensive traders need to remember is that there are a few key reasons why the level of failure is so high. We will examine each of these in turn. As we go through them and learn from the errors of others, we will be ensuring we do not suffer the same poor performance. The factors that make the difference between success and failure are: 1.Trading system 2.Trading psychology 3.Commission 4.Skill 5.Money and risk management Each is discussed in greater detail on the following pages. 34

Trading Stock Futures

1. Trading system If you buy and hold shares, your system is relatively simple. Of course you need to research companies and, if you are particularly good at it, you might have bought Coca-Cola in 1960, Microsoft in 1988 and Yahoo in 1997. If your skills are more modest you might have bought Pepsi in 1960, Apple in 1987 and Infoseek in 1997 – still not bad results. The point is that buy-and-hold on the whole produces good results over long periods of time, especially if you re-invest your dividends. Short-term trading by its active nature requires a more developed trading system. Many of the 90% of short-term losers simply do not adequately understand trading system issues. That is why several chapters of this book are devoted to looking at system design and construction; to help avoid you becoming a statistic.

2. Trading psychology In discussing trading strategies and system design, one point should be emphasised. If you can’t beat a buy-and-hold strategy then you should just buy and hold. Short-term strategies can beat buy-and-hold, but because you are actively trading you do need a disciplined approach to your trading. It is these psychological elements that can let the short-term trader down. Because you are trading very regularly you are called on to make decisions far more regularly than a buy-and-holder. Each decision, whether you are deciding what to do when sitting on a profit or a loss, or wondering whether to get in at all, is an issue of trading psychology. Many traders simply have not mastered the issues surrounding trading psychology and that contributes to the 90% of short-term trading losers. We discuss trading psychology issues towards the end of the book. “You should probably study psychology rather than math to trade…that is why Tom Baldwin is so good - he's a psychology major, he knows when and why people are sweating and how they are likely to behave.” Paul RT Johnson Jr, Senior Vice President, ING Barings

3. Commission Commission costs are another factor that impact more heavily on short-term trading than on longer-term trading. It’s one reason why, when testing a trading system, attention has to be paid to the post-commission profits to see if they are better than what could be achieved with a buy-and-hold strategy. 35

Alpesh B. Patel on Stock Futures

Many short-term traders have successful systems or can make money until commission costs are factored in. Some just assume commissions are too small a factor to make a difference between profit and loss. They are not.

4. Skill Compare a buy-and-hold strategy to the challenges faced by an electronic daytrader. The latter is pitting his wits against the market makers from Lehman Brothers. It is going to take a lot more than reading books to succeed at shortterm trading – even if the book is as good as this one! With a buy-and-hold strategy you may be able to get away with reading a few books about Warren Buffett, going out and buying some blue chip stocks and do okay in 30 years. But short-term trading relies far more on experience to succeed. Please remember, this book, and all the books in the world on trading, will not be worth a month’s trading experience. But if you do not read them, then that first month of experience is going to be far more expensive than the cost of the books. 90% of short-term traders fail and most of them do so in the first year of trading – when they have the least experience. Of course experience is not enough – ask Victor Niederhoffer or John Merriwether, two leading hedge fund managers whose funds ‘blew up’ with unexpected losses after years of success and at a time when they were revered as legends in the business.

5. Money and risk management When you are short-term trading you are of course ‘churning’ or turning over your capital much more frequently than if you are investing long-term. For that reason it is important to have calculated your risk/reward levels very carefully and worked out how much of your total funds you should risk on any one trade. Failure to do so is a key reason for the failure of many short-term traders. We cover this issue in some detail in this book to make sure you are well equipped to side-step failure.

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Trading Stock Futures

What is the essence of profit in the markets? The most difficult thing for any trader is knowing when to pounce and jump into the market. Before we look at how professionals do it, let me take you through something which will help you immeasurably. Making trading rules by which to enter, let alone exit, the market can sometimes feel like trying to solve Rubik’s Cube: you get one bit right (for instance, the number of losing trades is low) only to find that another bit is not quite right (the profits from your remaining trades drop). In this chapter we examine the nature of a price move and what you should know before designing your own rules or using those of someone else.

Price moves If you are looking to go long the market then ideally you want an indicator that will get you in as close to the bottom of the rise as possible. The problem with many indicators is that they get you in either: • Too early: So that the market keeps dropping after you enter only for you to find that it knocks out your stop loss, or to find you should have entered later to make more money; or • Too late: In which case you often find you make very little profit because the bulk of the move has gone or, worse, the signal is so late the trend has reversed. Have a look at Chart 2.1 overleaf. Some indicators, let us say the momentum indicator, will signal a buy at point X. It could be any indicator, and when you develop your own rules you will find some of your tests result in a signal at that early point. Another indicator, let us say the stochastic, will generate a signal at point Y. And other indicators still will generate a signal at point Z. Now, as things stand, one of three things could happen. From point Y the price could dip and move higher, or it could dip and dip lower, or not dip and just keep rising. All things being equal, we do not know what will happen when we are at point Y. Of course, looking at other indicators and factors we may conclude that one event is more probable than another, but we never know. That is what makes trading difficult. It is all probabilities. If the price dipped and then dipped even lower and you entered at Y then by the time you got out you would not have suffered as big a loss as getting in at point Z. The other benefit of getting in at point Y is that if the price actually dips and rises, then you would make a bigger profit than if you got in at Z, and also would probably never go into negative territory. 37

Alpesh B. Patel on Stock Futures

Chart 2.1 – Timing your entry

Indicator or entry rule triggered too early

Price action

Result

Price continues dropping after entry, then rises.

Little profit. You miss out on some profit.

Price continues dropping after entry, then falls more.

You make a loss.

Indicator or entry rule triggered too late

Price action

Result

Price has only a little further to rise.

Little profit.

Price turns round and starts to fall back.

You make a loss.

So you prefer indicators that give a buy signal at Y over those that give it slightly later at Z? But that seems too obvious. The problem with indicators that give buy signals at Y is that they are triggered by a small price rise that can occur so often in everyday declines. In other words, lots of false signals are generated. The 38

Trading Stock Futures

small price rise that triggers the buy signal at Y, does not trigger the signal at Z. So Z avoids lots of small losses. We now have a trade-off to face. The early indicator gives us more profit compared to the later one if the price continues upward, and less of a loss if the price dips after triggering the later indicator. But all this comes at the expense of having more losing trades that are avoided by the later indicator. What should you do?

The prime concern in any system is what makes the most money, the system triggered at Y or at Z, and that is the determinant. I have often found that the indicator giving the buy signal at Y is the one that is more profitable. The problem is that as soon as you get the signal at Y you can do one of two things the next morning: • You can buy on the open This is not recommended. If you wait and the price falls, you will have saved yourself from a bad trade, and will have the option of entering later at a better price. • You can wait to see if the price rises and then buy That is what I prefer to do. But if only life were that easy. What do you do if the price does indeed fall from the open, but at the close your indicator still says buy? Well, you go with what the price is doing, not what the indicator is saying. If the indicator says buy and the next morning the price falls, you should not buy. When do you get in?

I would wait for the price to break the preceding day’s high, or break the level it reached when the buy signal was first given. (I know this all seems convoluted, but you will encounter these problems yourself and wonder what on earth to do, so persevere.) This way, if the price keeps falling, you are okay because you never got in. But on the downside, all this waiting means you could enter at such a late stage that the whole move has expired. It is this sort of dilemma that may well make you think the market is out to get you and lead you up the garden path. Another analogy is of the market like a bucking bronco horse trying to throw you off. Fear not, she teases everyone, do not become paranoid, that is the way of the markets.

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Alpesh B. Patel on Stock Futures

How do you know when to buy and sell? The eternal question, the question that weighs on the mind of every trader is: will this stock rise? This question is at the heart of any choice about a stock – all other questions flow from it. One way of evaluating whether a stock will rise is to analyse how the price has moved in the past. In this part of the chapter we are going to recap the hardcore elements of technical analysis (TA) for stock futures traders – a recap for those who know it, and a brief introduction for those who do not.

A review of technical analysis You will face many queries when trading stock futures: • How do I know which securities to buy? • Even if I know what to buy, when is the best time to buy it so I reduce the chances of the stock going down right after I have bought it? • What are the signs that a security is ‘tanking’ i.e. ripe for a fall? However, you have the ability to tackle such problems. The reason for using TA is to get a good idea about when to buy low and sell high. What is technical analysis?

Technical analysis is a method of determining opportune buying and selling points. It involves methods used to forecast future prices using the price data alone (for example by plotting it as a chart and noting direction), or using the price as an input in mathematical formulae and plotting the results. Contrast this with fundamental analysis, which looks at a company’s accounts, reports, etc., in order to determine value. TA tends to work best over a time-frame of a few days to a few months, so is ideal for short-term to medium-term trading. Many of the indicators and methods of analysis we will examine are trying to determine when traders may have overreacted and therefore have sold too much stock too quickly, or vice versa, and therefore afford us the opportunity to enter or exit the market at the best time to maximise profits. But TA does not always work. It cannot explain everything in the market, since the market does not behave in a consistent manner. Whenever we use TA, or any other form of analysis, we are, in fact, looking for points where there is an increased probability of a price move. We look for areas into which it is highly probable that the price will move. 40

Trading Stock Futures

The tools and the strategies

I am not going to go through every single analytic method known to man. I am going to focus on the techniques I use, that are the most popular, and that the major institutions use. At the end of this section you won’t have a PhD in TA, but that doesn't matter - you're going to use TA, not lecture on it. Charting

Bar charts Bar charts are the most popular ways of depicting prices. We are going to examine how stock futures traders use them. For now we shall just take a toedipping overview. The extremities of the price high and the low determine the length of the bar. The horizontal line on the left of each vertical line represents the opening price, and the horizontal line on the right represents the close. Chart 2.2 – Example of a bar chart

Japanese candlestick charts With Japanese candlestick charts there is a body and a line (like a wick). The body is a rectangle drawn between the open and close of the day. It is shaded black if the close is lower than the open, and white if the close is above the open. The wick is added to join the high and low of the day. Of course, if there is no price movement after the open then there will be no body or wick, just a horizontal line.

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Alpesh B. Patel on Stock Futures

Chart 2.3 – Example of a candlestick chart

Supports are trendlines that join previous lows. Resistance join highs. When a support or resistance level is broken it tends then to reverse its role and become a resistance level or a support level respectively. This is a common occurrence known as a reversal pattern and the same rules apply as before. After a breakthrough of a support or resistance the price will often pull back to the trendline it just broke through. You have to be careful of this as you may think the move has just ended, in which case you may exit an otherwise profitable trade prematurely. Using technical analysis as part of a trading strategy

Before moving on we should make a general point about how the TA tools examined are to be used as part of your overall trading strategy. Remember: 1.No single tool is sufficient as the basis of a trading decision. 2.The tools must be used in conjunction with each other, each providing further confirmation or not. Find out which tools are best for you. 3.The TA tools must also be used to precisely time your entry or exit from a position. Timing your entry or exit is critical, since it is not enough to think the price will rise or fall ‘in the next couple of weeks’. TA is a fine-tuner.

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Trading Stock Futures

Constructing a stock futures system Later in the book we will look at some tried and tested strategies. However, while some people just like to eat their cake, others like to bake it too. In other words, you may not just want off-the-shelf systems and strategies, you may want to develop your own. In this section we go through key principles and problems you may encounter in developing a robust strategy from scratch. In subsequent chapters we will examine how to resolve the problems.

Step 1 – Get the heads-up on price Before we can formulate a trading system, we first need to have a look at some historic price charts for stocks – note stocks, not stock futures yet. Chart 2.4 – A typical stock chart

Step 2 – Mark the chart with entry and exit points The next thing to do is mark on the chart where you would have wanted any system to get you into the market and where you would have wanted the system to have got you out of the market. See Chart 2.5 on the next page as an example. On it I have marked the entry and exit points that I would have wanted with up arrows and down arrows respectively. You might choose different ones. That’s fine. 43

Alpesh B. Patel on Stock Futures

Before you mark the chart, these are some points to consider: 1.You want buy signals to be generated just as a big move starts. 2.A big move is a matter of trading choice, but obviously it is one which if you had entered would be sufficiently large to overcome commissions and slippage and leave a healthy profit. 3.The corresponding sell signal has to be as close as possible to the peak of the move to extract as much profit as possible. Chart 2.5 – First chart marked with visual buy and sell signals

Remember, this chapter and the whole process is for someone wanting to develop their own system from scratch. If all this is turning your mind into mush you can just follow the ready-made systems which appear later in the book. The signals on Chart 2.5 were placed by eye. The up arrows indicate the points at which you would probably want to buy and the down arrows indicate the points at which you would probably want to exit. Later we will look at websites and software which can do this automatically for you. Indeed, you will be introduced to software that can calculate the optimal profits you could have earned in a theoretically perfect system with 20-20 hindsight. The aim of such an impossible signal generator is to give you a template against which to compare your own system’s signals to see how close they are to perfection. To illustrate the fact that your choice of buy and sell signals is a matter of personal choice, an equally valid equivalent to the previous chart could have looked like that shown in the next chart. 44

Trading Stock Futures

Chart 2.6 – Second chart marked with visual buy and sell signals

How do I choose where to place the buy and sell signals?

The major difference between the last two charts is that the buy and sell signals on the second chart are better suited to a trader who is looking to develop a system which does not keep him in the market for as long as the signals in the first one would. Hence the signals are a lot closer together. Profitability analysis – Charts 2.5 and 2.6

Chart 2.5 The total profit from a system that could have generated the signals shown on Chart 2.5 is $38,422 after commissions, as the table below shows. On an equity of $5,000, that’s a return of 768% in under one year and just going long. Table 2.3 – Profitability analysis of Chart 2.5 Trade 1

Trade 2

Trade 3

Entry Price($)

7

10

55

Exit Price ($)

12

60

165

3,554

24,984

9,884

Profit/Loss* ($)

* On purchase based on $5,000 equity for each trade (after $16 round turn commission)

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Alpesh B. Patel on Stock Futures

Chart 2.6 Total profit from a system that could have generated the signals shown on Chart 2.6 is $24,549 after commissions. On an equity of $5,000, that’s a return of 491% in under one year and just going long. Table 2.4 – Profitability analysis of Chart 2.6 Trade 1

Trade 2

Trade 3

Trade 4

Trade 5

Entry Price($)

9

10

17

26

66

Exit Price ($)

12

18

33

58

174

1,649

3,984

4,688

6,144

8,084

Profit/Loss* ($)

* On purchase based on $5,000 equity for each trade (after $16 round turn commission)

A simple buy-and-hold strategy would have produced around $125,000 profit! Remember, this is based on the hypothetical signals generated with the benefit of hindsight. Why do we look at signals of the kind shown in charts 2.5 and 2.6? Well we are trying to find a system to fit the signals, and this small illustration shows that where the buy and sell signals are positioned can make very big differences to the bottom line. When they are closer together, the profit levels between entry and exit are lower are generally lower. The better you understand the nuts and bolts of system manufacture from the bottom up, then hopefully the better the system you can design and more money you can make. So why would you want a system with signals closer together? This goes to the heart of why we would trade in the short-term at all, and is a question all traders ask themselves. There are several reasons we may want buy and sell signals closer together. As long as we can overcome commissions (which in stock futures trading are minimal anyway) you have the opportunity to capture the upward parts of all moves and be out of the downward elements, and therefore make a relatively little amount (relative to buy-and-hold sometimes) on each trade (because the time between entry and exit is small) but make a lot cumulatively (because you are doing a high volume of trades). To illustrate the above point check out the next chart.

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Trading Stock Futures

Chart 2.7 – When buy-and-hold is not the most profitable system

Table 2.5 – Profitability analysis of Chart 2.7 Trade 1

Trade 2

Entry Price

510p

530p

Exit Price

550p £4,000

Profit/Loss*

Trade 3

Trade 4

Trade 5

495p

500p

505p

625p

540p

525p

530p

£9,500

£4,500

£2,500

£2,500

* On purchase based on 10 Unilever stock future contracts (ignoring commissions) (1p move equals £10 change in value of the stock future contract)

The total profit from a system that could have generated the signals shown on Chart 2.7 is £23,000 before commission in under 1 year and just going long. On a buy-and-hold the corresponding profit is £0. And that's why we trade shortterm – to make money on the ups, and side-step on the downs. With 20-20 hindsight it’s easy to know when to adopt a buy-and-hold strategy and when to adopt a more active short-term trading strategy. Since we can’t foresee the type of market, we have to play the odds in the manner suggested by Table 2.6 overleaf. 47

Alpesh B. Patel on Stock Futures

Table 2.6 – Recommended strategies Stock trend

Strategy likely to produce best results

Up

Buy-and-hold

Sideways

Active

Down

Active

Step 3 – Overlay indicators So, we have our chart marked with the points at which we would like our indicators to produce buy and sell signals. The next step is to take the chart and add indicators to look for good fits. We’ll worry about tweaking and optimisation later, but for now let’s look at an example. Have a look at Chart 2.8: Chart 2.8 – Chart with MACD

MACD (Moving Average Convergence Divergence technical indicator) is an indicator suggesting when you should buy and when you should sell a stock. It works on the principle that as the stock runs out of momentum you should sell, and as it gathers momentum you should buy. Many technical analysts, or ‘chartists’ as they are often called, use it to give them an idea about which stocks to buy, hold or sell. 48

Trading Stock Futures

How does MACD work? MACD depicts the difference between the moving averages of the stock prices, for instance the average 26 and 12 day stock price. It is a moving average because the price moves each day (of course). How does this depict ‘momentum’? Historic observation shows that when MACD shows certain patterns, which we will discuss later, they tend to coincide with a change in direction of the price. A change of price direction is said to be preceded by the aforementioned change in momentum, in the same way that a ball thrown in the air loses momentum (or speed) before it changes direction and falls back down to earth. Many websites and software packages provide MACD indicators for free with price charts. The vertical lines on Chart 2.8 coincide with where we would want to see the indicator suggest buy and sell signals. Here I have chosen MACD purely for illustrative purposes. Anyone familiar with MACD and how it operates will see that the vertical lines are quite close to the MACD indicator’s buy and sell signals. Let's assume for the purposes of this example that we will apply the following trading system rules for MACD: 1. Buy where MACD is below 0 and moves above its own moving average (the dotted line). 2. Sell where MACD moves down across its moving average unless not already in an open position. 3. Place a protective sell stop at a loss of, say, 15%. By changing indicator parameters we could probably get it to be even closer – a process called optimisation. But we’ll come to that in the next section. But all is not bliss. Now we come to the problem with using just one straightforward indicator. The indicator also appears to give buy and sell signals in places we did not indicate on our price chart. Chart 2.9 overleaf illustrates the ‘extra’ buys and their corresponding sells based on the above rules.

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Alpesh B. Patel on Stock Futures

Chart 2.9 – Chart with signals generated by a simple MACD system

Whilst our system is basic and crude, the point is the same: on closer inspection the signals generated by merely taking a technical indicator will not produce particularly good results, especially when compared to the potential profit available in theory. So what are we to do to improve matters? Well, that’s where the beginner moves to the next level. We now appreciate that trading life is not simple, that the devil is in the detail and we need to be somewhat sophisticated. But all this is not to say technical analysis is useless, or that complicated strategies are better than simple ones, or that MACD is useless. In fact I prefer simple strategies to complicated ones and MACD is one of my favourite indicators. The point of this step-by-step exercise is to show that in trading system construction the answers are to be found elsewhere – beyond the very basic. Where that ‘elsewhere’ is will be revealed in the following sections.

Use different time-frames with stock futures My view is that the longer time-frame operates as a background force against which the shorter time-frame acts. While the shorter time-frame reacts to day-today forces, the longer time-frame is relatively unaffected by these. The shorter time-frame is being pressured in a particular direction by the longer time-frame, although occasionally an event (e.g. a law suit) can have such a significant impact on the stock price, that it operates on the weekly time-frame from the daily. 50

Trading Stock Futures

Posted by a trader on the Silicon Investor bulletin board:

One of the most fundamental techniques I have learnt from trading is to watch an issue simultaneously in multiple time-frames. Many seasoned, successful stock traders have learned to do this. The day chart is the most important to fully understand and monitor. Before I enter a trade off of an intra-day chart (or Level II action*; usually it's a hybrid) I will look at the day chart (in reference to the past 3-5 days) and ask myself if I still want to enter. When trading stocks intra-day, I watch the 30min, 5min, and 1min charts (occasionally a tick-chart, but less in the past couple of years as I've integrated Level II). The best setup is to have a screen with daychart, 30/5/1 min charts, all on the same screen. I do display volume on every timeframe and consider understanding volume in relation to price to be extremely important to stock-trading success (another topic). On each chart, I run a 10, 20, 40, and 50-period Moving Average (MA). As Linda Raschke (a leading US trader) says “always watch price relative to something else”. The best ‘something else’ is the MA. It represents a normalized reference point. So, when a stock is a certain % away from a given moving average, it tells you a lot. You learn more, that's repeatable that way. For example, when a stock gets out in front of its 10-period moving average (although it may stay extended for a while), it is inevitably much more vulnerable to pullbacks. Universally - it applies on the daychart, and intra-day (intra-day, for smaller pullbacks). When you're watching stocks on multiple time-frames, the higher timeframes ‘filter out the noise’ and provide you with greater perspective, leading you to trade in the right direction, and to always be aware of the trend.

* Movements based on screen showing not only the best bid and offer price, but 'market depth' that is all orders at all different price levels. Traders often look at this depth to gauge if there is more interest on the buy side or the sell side and so possible future short-term price moves.

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Alpesh B. Patel on Stock Futures

Chart 2.10 – A daily chart

The above chart shows at the point of the vertical line the stock moving sideways after a fall, with MACD showing some bullish signs. And . . . the weekly chart shows that MACD on that longer-term time-frame is moving sideways, fairly neutral and oversold, so should not stop us taking the buy signal on the daily chart.

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Chart 2.11 – A weekly chart

Looking at the daily chart again above, past the horizontal line shows that indeed we were right not to be stopped by the weekly chart on this occasion. If however, the weekly MACD had been falling sharply we would have known not to follow the buy signal on the daily website.

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Alpesh B. Patel on Stock Futures

Multiple indicators Traders base their decisions on the information available to them. That is not to say that volumes and volumes of information are essential – after all at some point you have to stop pontificating and pull the trigger. But there is a balance between too little information and too much. Most systems do not rely on just one indicator. They use a series of analytical methods and charting techniques to determine the best moment to strike. In the example above, it was evident that the multiple indicators gave a better picture than one indicator alone could. Of course, I chose an example specifically to illustrate that point, and there are many cases where even using a million indicators would not save a poor entry. Nevertheless, the principle that using multiple indicators will keep you out of more bad decisions than using a single indicator remains a valid one. A problem with having more information is that when some of it is contradictory it can lead to indecision. Then you find that if you had stuck to one indicator you may well have entered the trade and made a bundle. The real issue is whether the losses you avoid are greater or less than the profits you also miss out on when using multiple indicators rather than a single indicator. In my experience the rewards in terms of avoided bad trades with multiple indicators outweigh the missed profits that would have accrued from following just one indicator. I know it sounds like gobbledegook, but it makes sense if you read it one or two hundred times. Chart 2.12 – Daily chart with MACD

The above daily bar chart suggests the stock should continue rising as MACD is ascending. 54

Trading Stock Futures

Chart 2.13 below also suggests the stock will rise because MACD is rising from an oversold position. The weekly chart either reinforces our view or overrules it. Here it reinforces. If you look beyond the vertical line you can see how the stock does indeed rise. Chart 2.13 – Weekly chart with MACD

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Alpesh B. Patel on Stock Futures

DIY trading strategy So where do we go from here? The best advice to give you is: 1. Read a lot more about fundamental and technical analysis. 2. Develop a trading strategy. A trading strategy is a set of rules which must be met before you enter a trade, as opposed to trading tactics, which are the actual specific plans for what to do once you enter a trade (discussed below). Every individual’s trading strategy will vary and probably be unique, based on their own perspectives.

Steps to building a trading strategy Select some indicators

Having examined what fundamental and technical analysts commonly look for, and having done some reading about those subjects, choose some indicators you think may be potentially indicative of a rising market. Hypothesise!

Choose some rules you consider worth testing, bearing in mind the period of time you want to be in and out of the market for each trade. Choose a target price for exit, a stop loss figure and other circumstances for exit. Example trading systems

Fundamental analyst A fundamental analyst of company stocks might choose to buy a stock by following these guidelines: 1. P/E ratio less than 8 2. Analyst recommendations all being buy or higher 3. Profit margin of 10% or higher 4. Dividend yield of 13% or higher 5. Target price: Rise of 15% 6. Stop loss: Drop of 10% or below the 9-week low 7. Exit if one of these fundamental factors changes adversely

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Technical analyst A technical analyst may choose to purchase a stock if there is a: 1. MACD crossover – where the two lines on MACD crossover 2. Stochastic crossover – where the two lines on the stochastic cross over 3. Rising parabolic SAR* 4. Bounce off a trendline 5. Target price: Rise of 15% 6. Stop loss: Drop of 10% 7. Exit if one of the above technical factors changes adversely * Stop and Reversal - a mathematical indicator which moves closer to the price each day so that after a period of time, if the price reverses, an exit is signalled - but it should be, in theory, signalled earlier than other indicators because of the way it is constructed to move closer and closer to the price.

Overfitting There is a tendency when testing trading rules to overfit (i.e. tweak) the rules to the data at hand so the results are good for that data only. To avoid this, do some out-of-sample testing. In other words, test the same rules on a completely different set of data. But beware: it may be that your trading rules genuinely only work with that one company, both historically and in the future, and you may be throwing away a good system by out-of-sample testing. To avoid this, do some paper trades on the same stock as well.

Test the rules

Now test the rules. Select some stocks and obtain their historical price charts. Next, see what would have happened had you used your trading strategy. What would a notional $20,000 have turned into at the end of one year, after dealing costs? The preponderance of evidence rule

When testing and developing look for a balance of probability. Examine many different indicators, e.g. news stories on your product, analysts’ views, market momentum. When there is a preponderance of evidence suggesting price movement, do a paper trade. Keep doing this until you are comfortable that what you are doing works. If it does not, find out what aspects do not work. For instance, if a particular technical indicator is always wrong, either amend or ditch that indicator . . . be ruthless. Always paper-trade with different methods of selecting trades. For instance, you may try to combine stock filters with technical indicators and plot the results together with other systems, and go for what appears to make sense and is profitable. When you find a trading strategy you are fairly happy with you are ready to trade. 57

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Action plan: Step 1 1.Decide if you need or want to find out more about fundamental and technical analysis. 2.Find websites which provide analysis for your product choice. E.g. www.bigcharts.com 3.Choose sites which you like the best for fundamental and/or technical analysis. E.g. www.quicken.com 4.Develop a trading strategy using the guidelines provided in this chapter, then test it to satisfaction on paper or with small sums of money. How to back test • Test one indicator at a time and add more and more to see how that affects results. • Look at a chart and identify the points at which you would like your indicators to produce signals and then find indicators that successfully produce them. • Check to see if the results are very volatile i.e. generate large losses and profits (even though profitable overall). Ask yourself whether you can handle such losses along the way. • Do not just test bull markets, test bear and sideways markets as well, or find a different set of indicators for each type of market.

Action plan: Step 2 - creating a trading tactic 1.Using the trading rules contained in your trading strategy, go through the relevant stocks, etc. 2.Select the best possibilities for price moves. Remember the preponderance of evidence rule. 3. For each possibility list the pros and cons. Select the best of the best to trade. 4.Set an upside target*. What do you expect the price to reach and in what time-frame? You may want to attach a rough probability of this occurring. 5.Set a stop loss – a point at which you will exit the trade: Either a specific price level or a percentage. 6 Set a point at which you will sell irrespective of 4 and 5 in this list, i.e. you may get negative news on the company and decide to sell even though the stop loss has not been reached. * Hot tip – risk-reward: As a rule of thumb your upside target should be a greater percentage than your stop loss.

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Table 2.7 – Part of a simple trading tactic Pros

MACD crossover occurred Stochastic crossover occurred SAR upward Trendline bounce All analysts buy or strong buy Sector strong

Cons

Sector undergone long bull run

Stick to your plan

Stick to your plan. Do not start hoping for price moves, or denying losses. Try to keep objective. Do not get attached to a position; each day is a clean slate.

What you have learned • A trading strategy is a set of rules which must be met before you enter a trade, as opposed to trading tactics, which are the actual specific plans for what to do once you enter a trade. • Choose some indicators you think may be potentially indicative of a rising market (or a falling one). • Choose a target price for exit, a stop loss figure and other circumstances for exit i.e. hypothesize. • Beware of overfitting - there is a tendency when testing trading rules to overfit the rules (i.e. amend them) to the data at hand so the results are good for those data only. To avoid this, do some out-of-sample testing and do some paper trades on the same stock as well. • Test by selecting some stocks and obtain their historical price charts. Next see what would have happened had you used your trading strategy. What would a notional $20,000 have been at the end of one year, after dealing costs? • When there is a preponderance of evidence suggesting price movement, do a paper trade. Keep doing this until you are comfortable that what you are doing works. • If it does not, pinpoint which aspects do not work and amend them. • Test one indicator at a time. Look at a chart and identify areas in which your indicators should produce signals. Are the results very volatile? Test bull, bear and sideways markets. 59

3

Chapter

Trading Strategies I

Trading Direction

Overview In these chapters we get down to some popular and successful strategies used for trading profit from stock futures. Not simple basic strategies which work in theory, but those that work in practice and are actually used by traders. Before explaining these strategies, below is a quick reminder of how profits/losses are made when trading stock futures. Quick revision of stock futures profit/loss Example 1

BP is trading at 600p (bid) and 601p (offer). Assume that the BP stock future is at 604p (bid) and 606p (offer) and that you buy one contract. A month later the stock is 630-631 and the stock future is 633-634.5. If you close the position you make 633-606 = 27p x 1,000 (one stock future contract in a UK stock = 1,000 shares) = £270 profit. Example 2

Microsoft stock is trading at $65.50-$65.51, and the stock future on Microsoft is trading at $65.90-$65.93. Assume you sell 10 stock futures at $65.90. Each stock future represents 100 shares. A margin deposit for this trade of $10 per share is required, that is $10,000. Two months later, the price of the future is $64.01-$64.04, so if you close the position by buying the stock future at $64.04 you make $1,860 profit ($65.90$64.04) x 100 x 10 = $1,860.

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Trading direction Take a look at the Coca-Cola chart below. Chart 3.1 – Coca-Cola [KO]

With the Coca-Cola price at $56 (far right of chart) we want to know what position to take. How does a professional trader decide? In the rest of this chapter we look at the strategies used by professional traders to make such decisions. As you will see, they are built stage by stage, each stage providing more evidence of price direction.

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Momentum indicators First, we examine momentum indicators.

1. The MACD Let us start with MACD. Chart 3.2 – MACD, Coca-Cola [KO]

The MACD on the Coca-Cola chart suggests the stock is oversold. That is, it has been falling and has an increased probability of rising. How do we know this? Because there are rules of interpretation for all indicators, and the rules for the MACD when applied to the above chart point to Coca-Cola being oversold. MACD measures the strength of price moves and whether they are weakening and so prone to change direction. In order of bullishness this is what depictions of the MACD mean: 1. The thick black line starts rising. 2. The thick black line starts rising from beneath the ‘0’ line. 3. The thick black line starts rising from beneath the ‘0’ line and the black line breaks through the dashed ‘signal’ line. Okay, that is actually not enough evidence of the odds of a price move. But it is a good start. And it does tell us one important piece of information: We certainly do not want to sell short stock futures in Coca-Cola at this point. 63

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2. Adding the Stochastic Indicator But, what else do we want to look at in a directional trading strategy? Add the stochastic indicator – another momentum indicator but slightly different to the MACD – and see what that tells us. The stochastic indicator is interpreted in a similar way to the MACD, except that it is based on a different mathematical formula so does not give exactly the same buy and sell signals. If we use the MACD and stochastic together, and both show a buy signal or a sell signal, we have a stronger confirmation of what to do. In terms of interpretation we look at the relative highs and lows of the indicator to determine if the stock is ‘overbought’ (indicator at relative high) and so likely to fall, or ‘oversold’ and so the price is likely to fall. Chart 3.3 – Stochastics, Coca-Cola [KO]

The rules of interpretation for the stochastic indicator are pretty much the same for the MACD, but since the indicators operate differently they can provide corroborative evidence. In order of bullishness this is what depictions of the stochastics mean: 1.The thick line starts rising. 2.The thick line starts rising from beneath the halfway point (marked 50) which represents the point at which things change from being gradually oversold to gradually overbought. 3.The thick line starts rising from beneath the halfway point, and breaks through the dashed line. 64

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Now all the above may sound silly. But trust me you do not need to know the MACD means Moving Average Convergence Divergence or that it is a result of the difference between the 26 and 12 day exponential moving averages of the stock price. You just do not need to know that. It is good to know, but you can do that later…with your PhD in technical analysis if you are a TA geek like me. Where does all that get us? Okay, so what does our evidence in taking a directional punt on Coca-Cola look like presently? So far, and we have by no means finished collecting evidence, we know the following: • The MACD suggests Coca-Cola is oversold and we do not want to short it. • The stochastic, whilst it is not clearly bullish, provides some evidence that we may want to consider a long position in Coca-Cola.

Divergences Actually there are more interpretation rules than I gave you – and they are better. Look at the chart below. It is the same Coca-Cola chart that we have been examining on the last two pages, but this time I have removed the MACD (for clarity) and only shown the stochastic indicator. Chart 3.4 – Coca-Cola [KO] - divergence

Sharper observers will notice that I have also drawn two lines on the price chart. The one slanting downwards in the upper half of the chart shows the price making lower lows. The one slanting upwards in the lower half of the chart shows the stochastic making higher lows. An important additional bullish interpretation for the MACD and the stochastic is where there is a bullish or positive divergence between the stochastic and the price, with the price making lower lows and the stochastic making higher lows. 65

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Divergences are rather predictive of share prices. They are well worth focusing on alone. It is the charting equivalent of evidence so strong as to catch someone red handed! So we now have a decision to be bullish. Two questions arise. 1.When should we get in? 2.What profit target and stop loss exits should we set? 1. Getting in

I have a simple rule for getting in long on stock futures – the price must have broken yesterday’s high. If it has not, then it may continue falling and is not ready yet. 2. Setting price targets and stop losses

Setting these should be quick too: The potential reward should be double the potential loss. The stop loss exit point is a point on the chart you can point to today where all other things being equal, you know you are wrong and should move to the next trade. So how do you know you are wrong? Follow this bit carefully because it is very important. You know you are wrong when the price goes somewhere it should not if your original analysis was correct. Look at Chart 3.5. Chart 3.5 – Coca-Cola [KO] – stop loss

A good stop loss point is always a support level (or better still the other side of the support line). The price should not go there if you are correct. So the current price is $61.50 and the stop loss is $54. 66

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Because we want a reward of double the risk, we next ask, can the price be expected to go to $76.50? Look at the next chart with the exit and target profit areas marked. Chart 3.6 – Coca-Cola [KO] – profit targets

Of course for a longer term stock futures trade you can take wide profit and stop loss exit targets.

About stop losses Several important things about stop losses you need to know: 1.You can get out sooner (or close part of your position) if you feel you may be wrong. 2.You can adjust the stop loss tighter (not further away though) especially for a profitable trade. 3.Never let a trade which is in profit, slip back into a loss. Examples

Let us look at some more examples and the analysis that goes with them. Remember we only expect to be correct seven times out of ten – but expect to make more in the profitable trades to offset the others.

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Chart 3.7 – Coca-Cola [KO]

Chart analysis

Bullish points • The short-term trend is up. Bearish points • MACD is overbought i.e. well above the 0 mark. • MACD is turning lower. • MACD looks like it is about to penetrate its signal line (the red dashed line). • MACD shows a ‘negative’ or bearish divergence (price makes a higher high, but the MACD makes a lower high). Overall I do not want to be bullish on this stock at this point. Equally, given the strength of the uptrend I would want to enter cautiously, maybe increase the number of stock future contracts as matters became clearer once the price did indeed start falling. All this is fine as a starting point, but can we add more analysis to make the odds of a directional stock futures trade even better? Yes, we can. Let us look at each one.

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Weekly chart Look at Chart 3.8 below. It is Coca-Cola again, but on a weekly chart. Whilst we were looking at the daily chart, the weekly one shows different, longer-term forces at play on the stock. These tell me MACD is rising strongly – a bullish indication. And so any bearish indications on the daily chart may be short-lived. If I do go short on Coca-Cola stock futures, I will be keeping a close eye on it. Chart 3.8 – Coca-Cola [KO] – weekly chart

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Entry and exit triggers Just to make sure we do not get into trades prematurely I wait until the price moves above the previous day’s high before entering. Similarly if it is a long stock futures trade, then I may well, but will not always, exit if the price fails to make a new high relative to the previous day and then makes moves below the previous day’s low. Chart 3.9 – Coca-Cola [KO]

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Bollinger bands Bollinger bands, like all market indicators, have rules of interpretation. Look at the next chart, then we will decide if we want to make the stock futures trade. The bands are the lines surrounding price. They measure the stock’s volatility. Chart 3.10 – Coca-Cola [KO] – Bollinger bands

Chart analysis

Bullish points • The price is near the lower of the Bollinger band, which can often act as a support. • The Bollinger bands are wide apart suggesting increased volatility and so whichever direction the stock goes in it should go far. Bearish points • The price is not too far from the middle of the Bollinger band which can be a resistance level. Clearly the above analysis tells us several things we should look for when examining Bollinger bands for a stock futures trade:

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1. The narrowness of the bands

If the bands are narrow and constricted it suggests lower volatility. We should expect a sharp move as volatility reverts to mean and so increases – but until it does the price will move little. 2. Where the price is in relation to the bands

They can act as supports and resistances. Look at the next diagram. Widely spread bands suggest that whatever the other indicators, such as MACD, are telling us about the likely movement of the price, the bands should not immediately act as resistance to that occurring. Chart 3.11 – Coca-Cola [KO] – Bollinger bands

Examples

Some more examples focusing on Bollinger bands, but which in a normal stock futures trade analysis would of course be examined with other indicators.

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Chart 3.12 – International Paper Co [IP]

In the example above the price has exploded higher and this increased volatility has widened the Bollinger bands. The top band acts as a resistance. After such a sharp move and increase in volatility we expect the bands to narrow again and the price to take a breather and move sideways. So what kind of stock futures trade would we be inclined to place? Not a long one – probably a retracement trade. What’s that? I am glad you asked, I want to discuss it now. It is a trade where we short the stock future, expecting to buy it back cheaper later as the stock falls sharply. Web references for charts

www.bigcharts.com www.equis.com

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In the next two charts (3.13 and 3.14) we are waiting for the price to ‘retrace’ or fall back on its recent gains. For this to occur we need several things to happen: 1.A rise in the first place, i.e. some gains worth retracing. 2.Some indication the retracement is about to happen. This could be a MACD, stochastic sell signal, the price pushing a Bollinger band as well. The final trigger is usually the price, it will fail to make a new high relative to the preceding day or two days and you short when it falls below the one or two day low. 3.Some target. This can be measured by a retracement of 25%-50% of the gains in the rally stage. That is, whatever the price gained from trough to peak as it rose, it may fall back 25%-50% of that. Chart 3.13 – International Paper Co [IP] - retracements

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Chart 3.14 – International Paper Co [IP] - retracements

Judging the size of a move So how do you judge the size of the move, even if you have the direction correct? Personally I look at price resistance levels above where the stock is trading. These are levels the price has hit in the past and not broken through. The more often that has happened the less likely it will break through this time either. But, how long will it take to reach that target? Again I look at how long it has taken the stock to make similar size moves in the past. What if it is a new high? Then I simply extrapolate a continuation of the existing trend – that gives me an estimate of time and size of move.

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4

Chapter

Trading Strategies II

Diversification and Hedging

Overview Most traders use stock futures for short-term trading profits. But there is no reason why you can’t hold stock futures for longer periods, say months. How and why would you do this? Because it can be profitable, of course. Let’s see how.

Diversification Stock futures are listed on many international stocks. Clearly they are an excellent way to diversify a portfolio – but how and why? Research over the past 20 years reveals a peculiar aversion among investors to buying into foreign markets. Everyone says how important diversification can be to the private investor. By investing in a range of uncorrelated stocks, risk can be minimised. So you’d think that investors would look to diversify in the ultimate of non-correlated stocks – those of different countries.

One at a time The equity markets of different countries display an ideal degree of noncorrelation. For example, of the G7 nations, returns on the US index as shown by the S&P 500 reveal international stock return correlations for the UK as ranging from 0.35 for Italy to 0.55 for France. This degree of fluctuation suggests that a UK investor would do well to diversify in foreign stock. The benefits of holding foreign stock can be demonstrated by examining the trade-off between risk and expected return for a US investor holding a portfolio of S&P 500 and then introducing a gradually increasing proportion of foreign stock. Our investor begins with 100% invested in S&P 500 stock. An introduction of 15% foreign stock will reduce the standard deviation (or volatility) of the overall portfolio and slightly increase expected returns. So it is possible to have your cake and eat it when diversifying in foreign stock. 77

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Studies show that US investors hold less than 5% in non-US stock. For UK investors it may well be lower. This is the worst possible proportion in terms of diversification. It produces higher volatility for almost no additional return. So why haven’t we seen a shift towards better diversification? One reason has been lack of knowledge. Yet with one financial instrument and one account with a futures broker you could own a diversified portfolio of foreign stocks from Sweden and Japan to Germany and Italy – via stock futures.

Maximise returns with stock futures How to maximise returns while minimising risk? It’s the goal that all investors should be pursuing. Diversification in non-correlated stocks is one approach. Handled well, it can reduce risk to negligible levels. It is similar to the system of risk-adjustment used by insurers: The larger the group of assureds on the same risk, the easier it is for an insurer to estimate the average likely loss per assured. For example, an insurer may predict that, on average, each assured will incur losses of £500. Premiums can then be set accordingly and risk reduced to a minimum – in contrast to predicting the likely losses of a single assured. Economics Nobel Prize-Winner, Harry Markowitz, pioneered the application of diversification techniques to portfolio management. He identified a mathematical relationship between risk and reward on the following basis: If • stock A returns 10% (reward) and returns have a standard deviation of 20% (risk); and • stock B returns 10% with a standard deviation of 20%; and • the correlation of returns between stock A and stock B is zero then • risk decreases as the number of equally weighted portfolios of stock is increased. Just as with the insurer’s risk-assessment process above, the more diverse the holdings of stock, the less risk. In Markowitz’s example a risk of 20% against a reward of 10% becomes a risk of 14% when two equally-weighted portfolios are used instead of just one. Reward remains the same at 10%. And as more non-correlated stocks are introduced, the lower the standard deviation or risk becomes (to a limit of zero). This is the ‘benefit of diversification’. If you don’t understand the maths used by Markowitz, don’t worry. The important point is that diversification of a portfolio among non-correlated assets can reduce risk without reducing returns. 78

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Markowitz applied to futures Markowitz’s logic applies to futures as well as stocks. Using a simple trading strategy the value of diversification in the futures market is clear. So how diverse should you be? It’s difficult to set a figure. Much of trading is a question of personal choice. But we can see from the pros that the Securities and Exchange Commission requires that mutual funds own at least twenty different securities. The Commission aims to protect investors so it can be assumed that twenty is a reasonable minimum for an individual portfolio as well. That’s the easy bit – a reasonable minimum of diversity. What of the maximum? Research has been done on the risk of investing in stocks using varying numbers of stocks in the portfolio. The studies showed that the more stocks you own, the lower the risk - BUT only up to twenty holdings. It seems that twenty is the ideal, if not necessarily the absolute maximum, diversification in terms of risk reduction. After twenty, you’re expanding your holdings but no longer reducing your risk appreciably.

Now for stock-picking Now that you’ve considered diversification in terms of number of holdings, you should look at diversification in terms of type of holdings. Ultimately your decision will be a matter of personal choice – the particular industry groups that you have some knowledge of etc. Nonetheless, here are a few pointers: 1. Spread your portfolio across at least twelve different industry groups. 2.The 10% Rule: Don’t invest more than 10% of your portfolio in a particular industry. 3.The 5% Rule: Don’t invest more than 5% in one stock future. Points 1 and 2 focus on minimising sector risk – the risk of over-exposure in one sector area meaning that the portfolio will be damaged by adverse developments in that industry. A slump in one industry sector should not hurt the portfolio unduly if you’ve spread risk among at least twelve sectors and restricted exposure to any one sector to 10% or less. Always be aware of volatility figures for an industry sector you’re contemplating investing in. Frequently, specific industry sectors underperform even when the rest of the market is buoyant. For instance, at the time of writing the FTSE 100 is up 20% in a year, but the electronics sector is only up 2%. 79

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That is why restricting yourself to no more than 10% invested in any one sector is sensible. Even a 50% slump in a sector should not reduce the portfolio value by more than 5%. The choice of sectors can affect the diversity of the portfolio. Some sectors tend to move out-of-sync with one another. Airlines and oil stocks, for instance, are well known for being negatively correlated. Airlines benefit from lower oil prices; oil stocks benefit from higher oil prices. You’ll be making a wise choice if you diversify into both sectors. Conversely, oil stocks and oil service stocks are an example of two highly correlated sectors. Unlike airlines and oil, this isn’t an effective diversification – your eggs are still in one basket. As the markets move and sector percentages shift over time, you may want to regularly rebalance your sector weightings back to your original allocations. If a sector rises markedly in value, for instance, its representation in the portfolio may rise well above 10%, calling for a cutback in that sector to the 10% level. The final point listed above (point 3) aims to reduce exposure to a specific risk, that is, the risk of a particular holding going under. By investing no more than 5% of the portfolio in any one stock, you’ll protect yourself against such unforeseen failures. Minimising your exposure on any one stock to 5% or less will ensure that even if an individual stock tumbles 50%, it shouldn’t decrease the overall portfolio value by more than 2.5%.

Risk spreading We’ve considered diversification by number and type of holdings. Lastly, we come to diversification by physical criteria: spreading risk across companies of varying sizes, geographical regions and styles of management. Why? The stocks of big companies and small companies don’t necessarily keep pace with each other, so owning both large-cap and small-cap stocks is another way of diversifying. You might also wish to diversify by expanding into foreign equities. Just be sure that the portfolio lowers rather than exacerbates risk – foreign stocks tend to move out of step with domestic stocks. Another way of diversifying is by owning both growth and value stocks. This may help further spread risk, because growth investing and value investing tend to move in independent cycles. The key thing to remember about diversification is that it is a good thing. Just make sure that the diversification plan you choose is in tune with your investment strategy. It doesn’t have to be complicated; it’s really just a question of sensible management.

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Hedging We have dealt with diversification, now let’s turn to hedging with stock futures. When we hedge using stock futures we are simply talking about owning stock and selling a stock future to neutralise the risk of the stock. Let us take an example. You own 100 shares in Microsoft. You fear it may fall from $50 to $40. You sell one Microsoft stock futures contract, which is the equivalent of 100 shares of Microsoft. Microsoft does indeed fall to $40. On the stocks you are therefore down $1,000 (100 x $10). Since the stock future tends to move in tandem with the stock its price should also fall by $10. So you should be able to buy it back $10 cheaper across the 100 shares it represents – or make a $1,000 profit. The stock future profit equalises the stock loss – that is a hedge. You do it when, observing some of the stock prediction and charting techniques we mentioned, you expect the stock to fall in the short-term. Why hedge?

The reasons for making a hedge are: 1.You do not want to sell the stock because you are a long-term holder in it and simply want to protect against some shorter-term falls using the stock future. And selling a stock future and buying it back to close is much cheaper than selling stock and buying that back. 2.You do not want to sell the stock because that may crystallise a taxable gain. 3.You do not want to sell the stock because in buying it back later you may be subject to tax. For example, in the UK stock purchases cost 0.5% in stamp duty tax on the value of the transaction. So why not always hedge?

Because there is an opportunity cost to hedging too. If the stock rises you do not make the profit you would have made if you had not taken the hedge. That’s the problem with any insurance policy – there is a cost if the event you are protecting against does not happen. Problems

There are issues with hedging to be aware of. Hedges are not perfect because the price of the stock future and the stock will not be exactly one for one. Furthermore, if you do not hold the underlying stock in the exact multiples covered by the stock future – say you have 156 shares in Microsoft – then the hedge will not be perfect because you cannot trade in 1.56 Microsoft stock futures contracts. 81

5

Chapter

Trading Strategies III

Pairs Trading

Overview There is a reason why hedge funds have been in vogue – the strategies they use make money. With stock futures, other traders at long last have the opportunity to partake in such strategies. This chapter shows you how.

Pairs Markets go through cycles and consequently so do the types of investment styles that make money. In 1999 buying technology stocks made money, then from 2000, it was shorting that was lucrative. So is there a style that makes money in sideways markets? Thankfully one strategy makes money more consistently than most: A marketneutral strategy. And what’s more, it works in rising and falling markets too. It’s been around since 1949 and is widely used by hedge funds. Thanks to new online products and websites it is now accessible to private investors. Indeed, they should probably forget stockpicking and opt for this style instead. In this chapter I explain the reasons I find this type of trading so compelling, and why an increasing number of my trades are market-neutral. First, two key terms:

Correlation: If two securities are correlated ‘1’ then they move in tandem, if ‘0’ then they are not correlated and if ‘-1’ then they move in exactly opposite directions. Mean reversion: Mean reversion refers to the tendency of something to return to its average.

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Market neutrality What is a market-neutral trade? In a market-neutral trade one might buy one stock (stock A) and sell another (stock B). The profitability of the strategy is then governed by the outperformance of stock A over stock B, and not by the overall performance of the market. Hence, ‘market-neutral’. If the market falls, and along with it stock A also falls, the strategy still makes money as long as stock A falls less than (i.e. outperforms) stock B.

Pairs trading A popular form of market-neutral strategy is the pairs trade. With a pairs trade you examine how two related stocks perform relative to each other. You might, for instance, choose two pharmaceutical stocks – AstraZeneca and GlaxoSmithKline. You would buy the stock expected to outperform and sell short the one expected to underperform. A market-neutral strategist tries to identify the historical price difference of this pair, and acts upon temporary contraction or expansion of this difference. That difference has an extremely high probability of staying within a range, because related stocks (e.g. those in the same sector) tend to move in tandem. Knowing the historical difference, the idea is to buy at the bottom of the range and to sell at the top. Even if the market falls or rises, the one you bought should outperform the one you sold. For instance, if the outperformer falls from $100 to $80 you lose $20. But if the underperformer, which you sold, falls from $100 to $70 (i.e. underperforms), then you have made $30 profit on it, or a $10 profit overall. Similarly in a rising market, if the underperformer, which you sold, rises from $100 to $120 you have lost $20. But if the outperformer rises from $100 to $130 then you have made an overall profit. Calculating which stock to buy and which to simultaneously sell short required specialist software in the past. Today, numerous websites do the calculations. Web references: market-neutral sites

www.tradetrek.com www.pairstrading.com www.marketneutralstrategy.com Normally a pairs (or relative value) trade is opened with sufficient stock futures to give approximately equal values of each underlying stock. 84

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Example 5.1 – Pairs trading

You think in the German insurance market Allianz will underperform Munich Re. So you buy Munich Re futures and sell Allianz futures. • • • •

Allianz Stock quote: 350.05-350.08 Allianz Future quote: 353.50-353.60 Munich Re Stock quote: 310.20-310.25 Munich Re Future quote: 313.30-313.40

To make it a market-neutral trade you want to take out the same value trade in both stocks. Let us say you want to take a €1m trade in both. • buy 1,000,000/(310.2 x 100) = 32 Munich Re contracts; and • sell 1,000,000/(350.05 x 100) = 28 Allianz contracts After a couple of months both stocks have risen: • Allianz Future quote: 360.25-360.27 • Munich Re quote: 328.00-328.05 Both have risen but one has outperformed the other. Although on the short position – that is the one you sold first, Allianz – you have lost €18,900, on the long position, Munich Re, you have gained €46,720. Your net gain on the strategy is €27,820. Little wonder from around 20 hedge funds using that style in 1990, there were 1,200 following it in 2001 - one in five of all hedge funds. So why is pairs trading so compelling?

Such trades offer equity-like returns with bond-like volatility or risk. For instance, according to Hedge Fund Research these strategies have yielded over 10% annual returns for hedge funds since 1990. And their volatility was only around 4%. That beats the FTSE and the S&P 500 on return and on risk. Greater returns for lower risk – I know what I prefer. Moreover, market-neutral strategies are a trading style for all seasons – sideways, rising or falling markets. Even the Warren Buffett style of value investing, by his own admission, can have long periods of poor performance. Market-neutral strategies, whilst not guaranteeing all trades will be winning trades, work in all markets. Market-neutral trading is easier now than ever before. That is thanks to the popularity of online trading in contracts for differences, spread betting and the recent arrival of Universal Stock Futures in Europe and Single Stock Futures in the US – these instruments are all used for market-neutral trades.

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Chart 5.1 – Pairs trade – Microsoft v IBM

Look at the chart above showing Microsoft and IBM in the top half. It shows how their performance varies. The chart underneath shows correlation between the prices. That is – when they move in the same direction and when they diverge. A stock futures pairs trade on this information (which websites mentioned in this chapter depict) would go through the following thought processes: • Which stock is outperforming? For instance, is Microsoft outperforming IBM? • Are their movements uncorrelated (i.e. are they moving in opposite directions), such that we now expect them to both move together, because the stocks go through cycles of correlation and uncorrelation. • If so, then we would expect the underperformer (IBM) to start performing better and the outperformer (Microsoft) to start underperforming. As correlation increases they will move in the same direction (if it is upwards then IBM will rise faster than Microsoft). • So we are buying IBM and selling Microsoft stock futures. We would look to sell the overperformer and buy the underperformer on the basis they are about to revert back to their normal relationship.

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Additionally, cost savings of online trading means these trades are now viable for private investors who do not have the cost advantages of hedge funds. Naturally this is not for everyone; skill and experience are vital. You must read widely about them, practise on paper first, then start with small live trades. Impatience is the greatest killer of a promising trading future. Finally, market-neutral is not risk-free. Extreme market movements of the kind that happened in 1999 can mean the strategy lags other strategies. Nevertheless, if I start my own hedge fund, it will be a market-neutral one. Further references

Hedge fund investments for institutional investors: www.rosaltmann.com/hedgefund.htm

Pairs trading with ‘beta adjustment’ Let us say you believe Telecom Italia will outperform Eni over the next few months. But if that is outperformance based not on the general market movements but due to the differences between the two companies, then we have to allow for that. Now most traders will not make a beta adjustment and that is fine and keeps things simple. But it is worth knowing. The beta of a stock is the proportion by which it tends to move for a 1% move in the broader index. For instance Telecom Italia has a beta of 1.2 relative to the FTSE Eurotop 100 Index. That means it moves 1.2% for every 1% the FTSE Eurotop Index moves. Eni has a beta of 0.6. (You can find betas by observing the share price movements relative to the indices or from websites mentioned in this chapter.) If you want to take out a €250,000 position, then you • buy 250,000/(10.01 x 1,000) = 25 contracts in Telecom Italia; and • sell (250,000 x (1.2/0.6))/(12.50 x 1,000) = 40 contracts in Eni. If the FTSE Eurotop Index moves, say, 5%, then with the betas we would expect Telecom Italia to move 6% and Eni to move 3%. But that is not relative performance difference due to the company but due to the general market movements. By buying the proportion of stock futures we did, we hedged out the movements due to the market. Those moves would give rise to no profit or loss in our trade. So, if after a couple of months, the Eurotop Index had fallen 5%, but both stocks fell 4%, that would be better than expected for Telecom Italia and slightly worse for Eni. Both stocks fell, but the trader makes a profit because the Telecom Italia stock has outperformed Eni allowing for expected changes given broader market movements. 87

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The importance of news How to know when a pair is about to converge or diverge? News is important. It allows us to get a feel for why the market is moving, then why a sector is moving, and so on down to why an industry or specific stock is moving. Not all news is the same. And each type of news has different uses for the trader. We need to appreciate the different types of news and how to use it. Types of news

Market news • Is the market in trouble? • Is there much negative news that will stop stocks soaring? • Are there economic problems in the economy, such as high inflation, low growth, strikes, political uncertainty, low productivity, all of which will impact stock price rises? Sector news • Which sectors are rising and which are falling? • Is there sector rotation? I.e. some sectors accelerate while others fall. • Is there growth in certain sectors? Industry news • More specifically, which industries in a sector are going through good growth? • Is there news about positive telecoms development or negative tobacco issues? Company news • Is the company generating a sound positive stream of news or is it warning of earnings problems? Good news flow should be reflected in strong upward price moves. How is the price faring?

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Fig 5.1 – News types

Trading Strategies III – Pairs Trading

There is a lot of information on the web and you have little time. Therefore, you have to know where to get the knowledge you need, and how to use it once you have it. Table 5.1 – Use of news Type of news

What it provides

How to use it

Newswire (also called market pulse)

A quick fire summary of news items. Limited analysis. Mainly just describes what has happened. You have to do most of the analysis.

Can give you advance warning of impending price moves. Most useful to short-term active traders because of its likely impact in the short term on prices

Columns (commentary)

A regular writer writes a daily or weekly piece on a particular issue such as telecoms stocks, emerging market stocks.

The columnist is usually taking the recent newswires and adding a bit more analysis and opinion to them, explaining their significance. They give you a clearer, better picture of which stocks we should investigate further.

Features

An infrequent, very detailed, special feature on a sector.

For the longer-term trader as usually identify longer term prospects. Often identify value stocks whose present stock price does not accurately yet reflect future prospects, or will gradually rise over time as the company ‘proves itself’.

Web reference: news sites

www.bloomberg.com www.marketwatch.com www.ft.com www.cnnfn.com 89

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Exercise - Surftime You have a go: Visit the four sites listed on this and the next page, and scan for two major economy or sector stories that suggest that further investigation may lead to good stocks to research. Remember as you do this: • • • •

The clue is in the headlines. It should not take time – the headlines should jump out at you. After the headline see which subtitle looks the most promising. Print out the story for later cross-reference to assist in your research. Also to keep in a folder, so that it can later help with your trade planning (more about this later) if you decide to buy the stock.

Jot down your findings here:

Site:

www.bloomberg.com

Headline:

_______________________________________

Stocks to investigate:

________________

___________________

________________

___________________

Site:

www.marketwatch.com

Headline:

_______________________________________

Stocks to investigate:

________________

___________________

________________

___________________

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Site:

www.ft.com

Headline:

_______________________________________

Stocks to investigate:

________________

___________________

________________

___________________

Site:

www.cnnfn.com

Headline:

_______________________________________

Stocks to investigate:

________________

___________________

________________

___________________

Question But surely if the story is in the headlines the stock price will already have jumped? Answer This can sometimes be true for very immediate price moves, but if you are a longer-term holder it need not be a problem. We are looking for the types of news stories that suggest the price is still yet to move up, and which are forwardlooking. For instance, stories with headings like: • ‘Telecoms undervalued’ • ‘Pharmaceuticals still further to ride’ • ‘House builders may end slide’ We would not be looking for headlines which are a historical reporting of what has already happened to the share price with little inkling of what may happen next: • ‘Tobacco stocks popped up yesterday’ • ‘Good morning for retailers’ 91

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The company Let’s assume that you have heard about a company and are interested in it as a potential investment – you may have heard about it from one of the sites above, or from a newspaper, or a friend. How do you gauge whether you should invest in this company as one to outperform its peer? The news is a starting point; but it’s time for you to think whether the company looks good enough for you. To find out news about a specific company using any of the excellent sites mentioned above is relatively easy as they all follow a similar format: • Ticker symbol: The first thing you need is the company’s ticker symbol, the abbreviation for its stock e.g. Microsoft’s ticker is MSFT. • RNS: A term you will find when searching for news on UK companies. Stands for Regulatory News Service. It will be raw basic news, with no interpretation. However, this news is useful precisely because it is an impartial primary source of information. • AFX are news articles from the Associated Financial Press. It is a newswire, and therefore opinionated – though, may not be an adequate opinion. What we are looking for in company news flow is an outperformer relative to an underperformer so that we can do a pairs trade of stock futures. Positive news items about the company • Winning new orders • Increasing orders • Entry into new sectors • New product developments • Good strategic alliances • Accelerations in current business model Analysts’ forecast

We also want to know what the analysts are forecasting upcoming profits to be. This is worth knowing because they receive regular private briefings from the company on how things are going and so are usually on the mark with their estimates. How to scan newsflow

Since there are many news items, and we want to be as efficient as possible – so we can make our money and actually have time to spend it instead of being in front of the computer all the time – we need to know how to scan these news headlines. 92

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The general rule is that news companies try to tell as much as possible in the headline. Consequently I tend to focus on headlines which common sense tells me are likely to include information of the type I am looking for. In the example below I have highlighted the stories I consider to have fulfilled that requirement from a series for Sun Microsystems. However, I may examine some of the others too, if I think I need more information about a stock. Examples

The following news flow for Sun Microsystems shows some headlines which merit further investigation: Table 5.2 – Example news headlines

Friday, August 11, 2002 11:56 PM

11:56 PM 11:56 PM 11:52 PM 11:51 PM 11:50 PM 11:50 PM 11:50 PM

11:39 PM 11:37 PM

Startup Axient Bets On Private Fiber Network -- WITH A 60CITY NETWORK, AXIENT GETS DEAL FROM NBC TO DELIVER BROADBAND OLYMPIC COVERAGE - CMP Media Vendors As VCs -- Money And Influence -- As the biggest technology vendors increasingly act as venture capitalists, what are they getting in return? - CMP Media Finding Components On The Web -- DEVELOPMENT PORTALS OFFER TESTED, CERTIFIED, REUSABLE CODE THAT HELPS SPEED PROJECTS - CMP Media The New Developer Portals -- BUYING, SELLING, AND BUILDING COMPONENTS ON THE WEB SPEEDS COMPANIES’ TIME TO MARKET - CMP Media Vendors Partner With Venture Capitalists To Fund Startups CMP Media The Two Faces Of E-Biz Management - CMP Media Sun teams with vignette - CMP Media Stealing Java’s Thunder -- Microsoft’s upcoming Visual Studio.net offers an integrated development interface, a new programming language, and programming shortcuts that should result in more-efficient Web development. A secondary, unstated aim is to slow Java’s progress. - CMP Media AMD, Intel draw 64-bit battle lines - CMP Media XML GAINS MOMENTUM -- ebXML emerging as EDI alternative for B2B transactions - CMP Media 93

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6:05 PM 4:14 PM 3:46 PM 2:47 PM 12:54 PM 11:02 AM 9:45 AM

GSA Awards FirstGov Contract to GRC International PRNewswire WRAP: Dell shares fall 11% on concerns about future sales growth (Update1) - Futures World News Select LinuxWorld Conference & Expo Exhibitor Profiles A to Z; Conference and Expo to Start Next Week in San Jose, Calif. - BusinessWire Stock picks of the week: EMC, Pfizer, Sun, Johnson & Johnson and H-P - Deborah Adamson First Ecom.com Inc. Announces Second Quarter Financial Results - BusinessWire Robinson-Humphrey Analyst Interviews On RadioWallStreet.com - BusinessWire Planet City Software Teams With CRD Capital PRNewswire

Thursday, August 10, 2000 11:01 PM 8:23 PM 8:13 PM

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Sun, Microsoft Java Battle Delayed - Unknown (cmtx-pc) James J. Whitney Named Forsythe Solutions Group’s E-Business Solutions Technologist - BusinessWire PVI, Sportvision, Inc. Named Winners Success Story Receives Recognition from Sun Microsystems, Computerworld Competition - PRNewswire

Trading Strategies III – Pairs Trading

Self-assessment quiz Questions (answers on the next page)

1. Which one of these is not something you would find a useful piece of market news? a) b) c) d)

Inflation projections Last year’s inflation figures Expected growth rates Possible foreign armed conflict

2. What is sector rotation? 3. What is another name for a newswire service? a) b) c) d)

Market wire Market rotation Market pulse Market beat

4. What type of trader is a newswire most useful to? a) An active short-term trader b) A medium-term trader c) A long-term trader 5. Which has the least analysis? a) Market pulse b) Column c) Special feature 6. Do stock prices always react to news? 7. Name a site that provides news on non-US securities by allowing you to enter their ticker symbols.

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Answers

1. (b) – Because they are backward looking. Whilst they are relevant in shaping this years expectations, they are too far in the past to have market influence. 2. Where sectors that were not increasing in price, start growing as money rotates into them and out of previously leading sectors. 3. (c) – Market pulse (used, for instance, by FT.com www.ft.com). 4. (a) – Active short-term traders, because such news even if not relevant in the medium to long term, does tend to influence the immediate share price which is of most concern to the short-term trader. 5. (a) – Market pulse – it tends to be factual reporting, not with opinion. 6. No – that is one reason why trading is so difficult. 7. FT.com.

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Pairs trading with different currencies With stock futures, one broker can give you access to both foreign and domestic markets. One of the interesting possibilities this opens up is that of doing a market-neutral, relative value trade across different currencies. For instance, if you expected Roche (a Swiss Pharmaceuticals company and so listed in Swiss francs) to outperform Merck (traded in US dollars) you could do a pairs trade on the companies across the two currencies. Let’s say current prices are as follows Table 5.3 – Initial sample prices for Roche and Merck

Roche Shares Roche Futures Merck Shares Merck Futures CHF/US $ exchange rate

Bid

Offer

CHF 117.0 CHF 117.8 $69.20 $69.85 1.65

CHF 117.50 CHF 118.30 $69.25 $69.90

If you buy Roche futures and sell Merck at $500,000 in value, then you • buy (500,000 x 1.65)/(117.5x100) = 70 contracts; and • sell 500,000/(69.20 x 100) = 72 contracts Assume that after a couple of months the prices are as shown in Table 5.4. Table 5.4 – Final sample prices for Roche and Merck

Roche Shares Roche Futures Merck Shares Merck Futures CHF/US $ exchange rate

Bid

Offer

CHF 126.25 CHF 126.50 $72.00 $72.20 1.65

CHF 126.75 CHF 127.0 $72.05 $72.30

Both companies have risen with the sector, but Roche has outperformed Merck with a net gain on the strategy of $17,150. That is: • 72 Merck contracts (loss $2.45 per contract) = 72 x $2.45 x 100 = -$17,640 • 70 Roche contracts (gain CHF 8.2 = $4.97) 70 x $4.97 x 100 = $34,790 • Net profit $34,790 - $17,640 = $17,150 97

Alpesh B. Patel on Stock Futures

Pairs trading: stock vs market performance This strategy is one of my favourites. You can place relative value trades between a stock and an index (that is the performance of the market as a whole). Obviously the first thing to decide is whether you think the stock will outperform or underperform the index. So, let’s say you expect Microsoft to outperform the S&P 500. As mentioned already, you would look to buy Microsoft stock futures and sell the S&P 500.

Why do I like this type of trade? Whether a stock is going to outperform the market as a whole can sometimes be easier to judge than whether two companies in the same sector, affected by the same industry matters, will diverge or converge performance. To get a feel for whether the stock will do well or not, look at its news, look at its fundamentals, and go for stocks just starting to release good or poor news which is not yet incorporated in the price. Let’s look at an example. Say we expect Vodafone to outperform the FTSE 100. Look at the prices in the table below. Table 5.5 – Initial prices for Vodafone and FTSE 100

Vodafone Vodadone Future FTSE 100 Index Future

Bid 130p 132.5p 5050

Offer 130.5p 133.5p 5051

Now, how do we structure this trade? If we buy the Vodafone stock future at 133.5 and sell the FTSE future at 5050, then, deciding on a trade value of £250,000 – the number of contracts traded is: • £250,000/(130.5 x 1,000) = 192 Vodafone futures; and • £250,000/(5,000 x 10) = 5 FTSE index futures Assume that a number of weeks later the prices look like those below: Table 5.6 – Final prices for Vodafone and FTSE 100

Vodafone Vodadone Future FTSE 100 Index Future

Bid 140p 141.5p 5140

Offer 140.5p 142.5p 5141

Vodafone shares have indeed outperformed the FTSE 100. The gain on the Vodafone futures is (141.5 - 133.5) x 1,000 x 192 = £15,360, whilst the loss on the index futures is (5,050 - 5,141) x 10 x 5 = £4,550, leaving a net profit of £10,810. Nice. 98

6

Chapter

Risk and Money Management

Overview Trading strategies are not the most important aspect of profitable stock futures trading. Ask any stock futures trader and they will tell you that profits have more to do with the things we discuss in this chapter. If you learn nothing else, read nothing else – read this chapter.

Introduction Money management tries to answer questions like: • How much of my money should I risk on a single trade? • How much money do I need to start trading stock futures? Money management is about as exciting as a date with an actuary. Unfortunately for stock futures traders, it is also essential to understand if you are to play the game and make money. Consider the simple fact that if you suffer a 50% loss, it will then take a 100% return just to break even. Not a nice prospect is it? That’s why you shouldn’t leave home without money management.

Calculating how much to risk Now, this may seem a bit detailed and tedious, at least that is what I thought when I first realised years ago that it was important. However, if you are serious about making money from trading then you just have to take another sip of the gin and tonic, and read on. Whether a trade is worth making depends on the risk-to-reward levels, not just on the signals your system provides. By risk I do not mean the size of your position, but the size of your potential loss. Imagine you are trading one contract of the Microsoft stock future. The same principles apply whatever product and time-frame you are trading. Each cent equals $1 per contract. Imagine you also have $10,000 in total capital to trade with. Your reasoning should run like this: 99

Alpesh B. Patel on Stock Futures

1.How much of my total equity should I be willing to risk? Most experts would advise anything from 0.5-5% of your total equity per trade. 2.In this case since you have $10,000 in total equity, the most you should be willing to risk in one trade is $500. 3.$500 is $5 movement (remember each cent is $1). 4.So, the maximum number of aggregate points you can afford to lose is $5. (I have said aggregate because if you trade one contract it would be $5, but if you trade two it would be $2.5 on each, and so on.) 5.There are now two considerations: For a good trading system your downside should be determined by your expected upside. So, if you are expecting $3 on the upside, you should not be willing to risk $5 on the downside to achieve it. 6.What should the upside to downside ratio be? Well, 2:1 at least. So the most you should be willing to risk, given an upside of $3, is $1.5 on the downside. That is good risk and money management. So your risk-to-reward ratio is 1:2. But how many contracts should you have? 7.You can afford to have three contracts because even if you lost $1.5 on each that would total $4.5, which is less than $5. So in that situation you would buy three contracts, and still limit your downside risk to 5% of total equity on the trade with a 2:1 reward-to-risk ratio. Wasn’t too painful, was it? Now, how about a whisky? Chart 6.1 – Microsoft [MSFT]

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Take a look at Chart 6.1. The stock is at $83. We might reasonably expect it not to drop below $75 because that is a sound support level (a level below which the price has tended not to trade). So our target should be $99. But there is no point having a target if we do not expect the same chances of hitting it as the stop loss. But how does it fit into all we have learnt about trading strategies? Take a look at the next chart. Chart 6.2 – Microsoft [MSFT] – price targets

Our analysis for it may run something like this: • The tightening Bollinger bands suggest a price breakout after the present period of low volatility. • The rising MACD from its oversold level and moving above its signal line suggests an upward price break. • Since the stochastic is overbought and moving lower we may want to wait until the price moves above the previous day’s high before entering. Our stop loss, where we know we are wrong, will be $41 because the price has not traded there for a while and should it trade there must be something wrong with our view and so it would be a fair point to exit. Our price target of $47 looks ambitious because it is well above the upper Bollinger band, but at least the price has recently touched that level and we expect the narrow bands to widen. 101

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Expert advice

“You have to have good money management. You have to ensure you are not going to be hopelessly underwater. You can have rules like maximum drawdown, or value at risk, or limits. You can also have your own internal rules like “this is too much money too lose.” You must have that in your mind and that you are not going to risk more than that at any one time. You have to make sure you are left in the game. That is very important. Once this is clearly established, you need fear, you need to feel that things can very quickly go wrong.” Bernard Oppetit former Global Head of Equity Derivatives, Paribas and… “The figure of merit is how much of your equity is at risk for each consecutive trade. The book suggests that 1 percent is a reasonable figure. This applies to the amount at risk, not the gross amount of the trade. For instance, if you could relatively expect to scalp a reasonably liquid stock without ever having a loss worse than $3/4 per share, then in order to trade 1000 shares, you would need to have $0.75 x 1000/0.01 = $75,000 in your account.” From a trader on the Silicon Investor bulletin board What if you limit the most equity you are willing to lose on a trade from 5% to 3%? In this case you would reduce your overall risk to 3%, but you also reduce the number of contracts you would be trading, so if the trade were profitable your rewards would be reduced. By reducing your risk, you protect your downside more. Imagine you risk 2% of your equity in any one trade. Allowing for the fact that your account size drops on each occasion, your initial equity would be down 50% after 34 consecutive losses. It is not necessarily a risky business

What are the chances of 34 consecutive losses? Well, if there is a 50-50 chance of profit on any one trade then the chances of 34 consecutive losses would be 0.5 (3/4) or one in 17 billion. Makes you wanna trade doesn’t it? What if I am willing to accept a 1:1 reward-to-risk ratio?

The upside would be that you would give the price more room for manoeuvre, i.e. allow the trade more space to prove itself; the price could drop further before you had to exit. But the downside is that if the price just kept falling you would suffer a bigger loss when you exited. Another risk is that you are not playing the odds and if you got a string of losers you could be wiped out. 102

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Expert advice

“With a trade you always look at a multiple upside to downside. But how much greater? A good rule of thumb for a short-term trade – 48 hours or less – is a ratio of three to one. For longer term trades I look for a profit to loss ratio of at least five to one.” Bill Lipschutz former Global Head of Foreign Exchange, Salomon Brothers

“The loser’s spiral – the dark side of trading All of us, as traders, normally sense that trading can become dangerous, if you let it get out of control when it’s not going well. It can indeed be a rather dangerous (risky) endeavour, financially speaking. A friend of mine, after trading marginally successfully for a few months, said to me "Man, I sense this is really dangerous – I could get into a lot of trouble here." He was right. There is one basic process that accounts for nearly all the trading ‘blow outs’; I call it ‘the loser’s spiral’. I know all about it, as I went through it myself several times, in the process of really learning how to trade more consistently. Only extreme interest in trading, and perseverance through travails got me through this one! I’ve never met a good trader who hasn’t been through grappling with this, either. As they say, "You must learn how to lose before you can win." It is ‘the filter’ which keeps most away from full-time, long-term trading success. It goes something like this (simplified for brevity). Trader makes a bit of money. Skills develop. Trader makes a lot of money. Trader takes bigger risks. Things going well. Then … Wham! Big loss. Wham! Bigger loss. Trader tries to ‘make back’ loss by taking bigger risks … and so on. The spiral is self-perpetuating. Think that won’t happen to you? Well, it happens to 80% of beginning traders within six to nine months (mileage varies depending upon prevailing market conditions). It happens to a lot of intermediate traders, and experienced traders. It happens to world class traders who run huge hedge funds, and it happens to people that have written scholarly books (e.g. Victor Niederhoffer) and who are geniuses. So don’t think it can’t happen to you – it will, unless you study the mathematics of money management, and carefully calculate how much you can risk, versus your total tradeable capital. The statistics are overwhelmingly against you, if you violate the cardinal rules (generally, if you are risking more than 1-5% per trade, depending on your trading style).

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For those with higher net worth, more tolerance for risk, or a longer timeframe (usually a combination of these factors), the parameters are different. But the basic idea is, if you are trading too "large" (of risk on each trade), sooner or later it will destroy you and blow you out of the game – probably sooner rather than later.” From a trader on the Silicon Investor bulletin board

Other factors to consider Market volatility The price could be moving about so greatly that the place where you have to put your stop to prevent you losing more than 5% of your equity is just too tight, and is likely to be hit. In that case you cannot place the trade. It is too risky. The upside might also be so small that you have to have a tight stop loss, and again it may have to be so tight that it would be easily hit and would not be worth your time. Chart 6.3 – Microsoft [MSFT]

In the above example you would not want a stop $1 below the current price because just looking at the way the price moves tells you it often does easily drop $1. 104

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Expert advice

“With a trade you always look at a multiple upside to downside. You can look at the percentage probability of a rise or a fall. The problem with that is that you may have many trades that are 50-50. So you are trying to set something up which may have a 8:1 pay-off. I think risk is asymmetrical. To achieve successful longevity, you have to focus on your losses, or drawdowns, or whatever you call them. It’s very simple. Just know what you are prepared to lose.” Bill Lipschutz former Global Head of Foreign Exchange, Salomon Brothers It doesn’t matter how big, little, right or wrong your position is. You have to know what you are prepared to lose. I don’t mean mentally prepared, I mean mathematically what can be lost when you enter a trade. You must not put yourself out of business. You have to be back. You have to be there tomorrow, the next day and the day after. If you manage the downside, the upside will look after itself. Of course, when you first put on a trade you do have target levels, levels at which you think you are wrong. The price levels of those targets should be determined as a result of your absolute dollar loss constraints. For example, let’s assume that the current price level of Microsoft is $25. Let’s further assume that your analysis of the latest round of trade negotiations between Microsoft and the US government leads you to believe that the stock will rise to $30, but due to technical considerations should not fall below $22. How large should your position be? The answer lies in the asset size of the account you are doing the trade for and its loss limit. One Microsoft stock future contract represents 100 Microsoft shares. So a 1 cent movement in the stock is the same as a $1 movement in the stock future. If you are only prepared to take a 3% loss on a $10,000 account, that is $300, then it follows that a move in the stock from $25 to $22 should only result in a $300 loss. From that it follows that you should only buy one Microsoft stock future. If you are wrong on the trade, your loss will be $300 and if your analysis was correct and you sell the position at $30, your profit will be $500.

Probabilities Strictly speaking you should calculate your reward-to-risk ratio based not just on absolute figures but expected profit and expected loss. What does that mean? Well, let me give you some (painless) probability theory first. Your expected gain is the probability of the gain occurring multiplied by the value of the gain. Trust me, this is relevant to trading. So, imagine there is a die. If it shows 1-5 I will lose $5, but if it shows 6, I will win $30. Should I take the bet? 105

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In this example, my expected gain is 1/6 (because the probability of a 6 on a die is 1/6) x $30 = $5. My expected loss is 5/6 x $5, that is $4.17. So, since my expected reward is greater than my expected loss, I should take the bet. Of course, I will lose more times than I win, but when I win, I should wipe out my accumulated losses. Trading the markets is a little like this. You could have a trading system that produces $30 profits one-sixth of the time and $5 profits five-sixths of the time. But note that your reward-risk ratio would not be 30:5. It will be 5:4.17. This is very important. If you forget the probabilities of your system, then you will think you are placing a more favourable trade then you actually are. So how do you calculate the probability? You could use sophisticated computers, or back-test your system and estimate. Remember, even in a game of dice, there are no guarantees, only theory and reality, and they seldom converge. Large price moves have a lower probability of occurring than smaller ones. My suggestion is not necessarily to be hyper-scientific, but to take probabilities into account in your calculations. Expert advice

“Even though I know I will get out after a certain loss, I consider the amount I have risked as the whole amount invested. Also, I look to see what percentage probability there is of a certain percentage rise and I compare that to the risk I am taking.” Bernard Oppetit former Global Head of Equity Derivatives, Paribas I would look at some kind of distribution of possible outcomes, such as a 50% chance of doing something special, or a 50% chance of doing nothing in particular, or a 50% chance of a small loss against a 50% chance of a great gain. There has to be some idea of the distribution of outcomes. “Successful trading is very difficult. The vast majority of those who try end up losing money. However, the few successful traders make huge sums of money – once they gain the knowledge and experience to be successful. During the inevitable ‘learning curve’ virtually all traders lose money. The tough decision is when to ‘pull the plug’ and give up day-trading if you are not successful. The following ideas may be worth considering: Are you financially secure enough to trade without the anxiety of needing a ‘paycheck’ at the end of every day? Do you look forward to the open of the market every day? In short, do you enjoy trading. If not, you are likely not committed to the extent that is required. Most people cannot excel at something they don’t enjoy. The most successful people are virtually immersed in their fields. 106

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Is your trading improving? If you have made several hundred trades, you should be seeing some improvement in your trading results. Keep detailed records of your trades in a spreadsheet. This will give you irrefutable data that show your results in black and white. Don’t argue with the facts. In addition to the statistical data, do you feel you are avoiding many of the dumb mistakes that you made when you first began trading? Are you trying to trade with some kind of plan, or are you just trading from the seat of your pants? Hopefully, after several weeks or months of trading, you are beginning to formulate some ideas on personal trading strategy to guide your trading. Even if not successful with a particular strategy, you will gain knowledge by learning that the strategy was not successful. Then you can modify or refine your system to improve performance. If you trade by the seat of your pants, you have no reference point to what you were doing that was unsuccessful. The decision to quit trading is a very difficult one. Do not let your ego prevent you from giving up trading. The odds are stacked extremely heavily against success. People who lose money are in very good company. Not being a successful trader should be nothing to cause embarrassment or to be ashamed of.” From a trader on the Silicon Investor bulletin board Expert advice

“I believe discipline could be a learned response. You could teach somebody to do it, but you really have to hammer it into them to if they have got a problem – you cannot let them ride it at all.” Jon Najarian, CEO, Mercury Trading You have to be very, very honest with yourself. The single biggest thing is that you need to have a goal for every trade that you make. So if I do a trade and, say, I am buying a stock at $30 because I think it is going to $35, then I know what my downside limit is; it is $25, because if I am going to make $5 if I am right, then I do not want to have to lose more than $5 if I am wrong. So if I have goal which I think the stock is going to reach, then as a minimum I set my loss at where I think the gain could be if I am right.

How much money to start with? A very popular question raised by many new traders is how much money they should start trading with. Well, the answer is not as simple as giving a figure. You didn’t think it would be, did you? Consider the rich trader and the poor trader. 107

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Rich trader

This trader has oodles of cash, let’s say $1,000,000 for argument’s sake. His problem is not whether he has the minimum needed to trade, but rather: ‘What is the minimum he should trade with?’ Just because you have a small fortune does not mean you should look to use it all in your trading. It is advisable to paper-trade first, then trade small, and gradually build your way up as your confidence rises. The issue of how much the rich trader should start trading with depends on his answers to the following: • • • •

How confident do I feel? How much trading experience do I have? Have I traded this product or time-frame before? How profitable have I been so far with the system I plan to use?

The other problem the rich trader has is one of opportunity cost. Does he really want to use all $1million trading a system producing 20% return a year? He may be better placing some money into other ventures. Poor trader

This trader is more like the rest of us. He does not have a silver spoon in his mouth. Consequently, he is wondering whether he has enough money to trade with at all. The first thing to bear in mind is that if you trade with money that is needed for other more pressing things, such as school fees, mortgage, clothing, food, then pretty soon you will lose it. You would simply be putting too great a strain on yourself to ‘perform’ to succeed. You should be trading with uncommitted funds. The minimum amount needed to trade depends on the following factors: • Those listed in the ‘rich trader’ section you’ve just read. • Broker account minimums (these are so low nowadays they are not too large a hurdle). • The volume of trading you are intending to do. If you are planning to day-trade stock futures, that means you will be expecting to make a lot of small profits daily. So you will be trading high volume each day, and incurring commission for each trade. Of course, the optimist will argue that he will reinvest all the profits he intends making back into his trading account. In which case, he may calculate a shorter time-frame than a year as a benchmark for profits. Whatever happens you would have to have enough money to make enough profits just to break even. The key point is that the lower the volume of trading, the less trading capital you need. Profits to make the endeavour worthwhile: If your system was likely to produce 100% a year return before commissions, then in the first month you may expect 9% return before commissions. To improve your profit, you can either; increase your trading capital, or your 108

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system’s return, or reduce commission costs by trading less while maintaining returns.

Understanding risk I would rather underperform and have a better risk-to-reward ratio than be a star performer taking great risks. Trading is not a one-shot game and in the long term I would be the outperformer. Even those who have some idea about risk use outdated, unsophisticated or discredited measures. Beta is a popular yet incomplete measure of risk. Beta measures how much an individual stock is likely to move with the general market. A beta of 1 means that a stock will tend to move lockstep with the general market, while a beta of 2 means that the stock will rise 2% for any 1% rise in the stock market, and fall 2% with any 1% fall in the stock market, on average. But beta can be misleading. For instance two stocks with the same beta generally have a different level of risk. Standard deviation is another common measure of risk and it too has deficiencies. For example it fails to weight historical share prices to give more significance to the most recent prices. New online tools remove traditional problems with risk measurement. This will potentially result in greater online trading returns. JP Morgan have taken their internationally and institutionally acclaimed RiskMetrics risk calculations and converted them for the private investor through RiskGrades www.riskgrades.com. Bear in mind one further piece of risk advice from JP Morgan, actually, the J. Pierpont Morgan: “The market will go up and it will go down, but not necessarily in that order.”

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The trading psychology of risk and money management As part of my endeavours to discover the traits of the leading traders in the world and what they can teach the rest of us, I interviewed some of the world’s foremost traders. The extracts from the interviews below focus on risk and money management – two essential components to trading success. Interview with Bernard Oppetit

former Global Head of Equity Derivatives at Paribas Great traders tend to be risk-averse The public perception of traders, propagated by trading scandals, is that they are attracted to wild risks and take massive gambles. Of all the traders I interviewed for this book, not one claimed to be risk-loving. Oppetit details the contrary view: “I am very risk-averse. I would definitely take the certainty of making $10,000 dollars than the 10% chance of making $100,000. In terms of economics, my personal utility function is very much concave. When we speak of risk in trading we are, of course, discussing price volatility. Price volatility cannot be discussed without an idea of probability. The probability of a stock’s price reaching your target can be derived from the historic price volatility of the particular stock. Consequently, risk, price volatility, and probability go hand in hand. Good traders wait until the probability of a favourable move is the greatest and the risk of an unfavourable move the lowest. Moreover, unlike non-professional traders, the great trader knows that risk and reward are not always directly proportional. There are very low risk and yet high reward trades.” Oppetit continues: “The important thing is to look at risk in a rational way, and an imaginative way. A good trader knows how and when to take risk and how and when to avoid risk. There are risks which should be taken and risks which should not be taken. The game is to distinguish between the two. You do not need to risk a lot to profit a lot. There are a lot of trades where you can make a lot of money which are not particularly risky. You may have to invest a lot of your time to do research and discover what is going on, but the actual money you invest may not be at much risk. There is a joke about an economics professor who is walking in New York with a friend. His friend notices a $100 bill on the sidewalk and points to the bill and says, "Look professor, a $100 bill."

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The economics professor replies, "No that cannot be so, if that was a $100 bill somebody would have picked it up already." Still I believe there are opportunities to make money with very little risk.”

Analysing risk and probability

So, how does Bernard Oppetit analyse risk and probability when he examines a position? “Even though I know I will get out after a certain loss, I consider the amount I have risked as the whole amount invested. Also, I look to see what percentage probability there is of a certain percentage rise and I compare that to the risk I am taking.” What Bernard Oppetit does when analysing a potential trade is to consider at risk the whole amount he is trading with. This is even if he knows that he will exit the position if the price falls by, say, 15% and, therefore, he would only risk losing 15% of his stake. He then examines the reward. He measures reward by examining the probabilities of various outcomes. You can only gain an idea of the reward if you examine the probability of it occurring. Bernard Oppetit would then compare the risk with the reward. For instance, an options position opened with $10,000 would place $10,000 at risk. To get an idea of his risk and reward ratio, Bernard Oppetit would then examine the likely outcomes and their probabilities. This would give him some idea of the reward he may get for the risk he is taking. (If he were being very mathematical he would sum the products of all the outcomes and their corresponding probabilities, and compare this figure to the amount risked.) Money management

Good risk analysis and management is not only about volatility and probability, it is also about good money management. As Oppetit explains: “You have to have good money management. You have to ensure you are not going to be hopelessly underwater. You can have rules like maximum drawdown or value at risk or limits. You can also have your own internal rules like "this is too much money to lose." You must have that in your mind and that you are not going to risk more than that at any one time. You have to make sure you are left in the game. That is very important. Once this is clearly established you need fear, you need to feel that things can very quickly go wrong. In devising a money management plan, you should consider the following: What is the most money I will risk on any single trade at any one time, i.e. what is too much to be lost? 111

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What amount must I avoid losing on a trade, given that I might lose on a consecutive number of trades, so that I do not become in serious danger of being out of the game? Once in the trade, what is the maximum percentage I am prepared to lose before exiting? Some decide this based on "value at risk," i.e. a mathematical calculation based upon the probabilities of various outcomes of all open positions, and hence the value of money at risk of the positions.” Facing a loss

When sitting on a paper loss a trader will indubitably experience immense pressure and fear. Oppetit continues: “It is very important to experience this fear to ensure you do not end up in that situation again. Fear is also a bad thing in that it will affect your judgment, in the same way elation would affect your judgment. You have to take a very neutral approach. So, experience the fear when faced with a loss, do not deny it. But use the fear as a means of loss prevention in future, not as a cause of ever-increasing losses. When looking at a new price you do not focus on the fear of how much you have lost, or the hope it may turn around: You have to ask, if you are a buyer at this new price, if you didn’t own it already, would you buy it? If the answer is no, then I sell it. You have to look at the position with an open mind, and ask if you would put it on today if you did not already have it. If new information came in while I had an open position, I would change my expectations. But you have to be honest with yourself. It is a question of attitude. It is an easy trap to fall into to kid yourself that you are holding onto something because you believe things have changed and it will now rise. It comes back to being honest with yourself.” Handling a profit

As well as hope, another damaging emotion surrounding open positions which prevents an honest analysis, is that an unrealised profit may vanish. It is a cliché that you should cut your losers and ride your winners – but it is very true. Most people and many traders do the opposite. There is a desire to take profits, sometimes encouraged by accounting rules. Many people look at their unrealised gains as non-existent. They think taking profit is making real profit and it is unreal before then. They feel taking a loss is an admission of being wrong. Again, this emotional attitude to profits has to be eradicated. Instead of focusing on whether he was right or wrong, Bernard Oppetit focuses on his expectations regarding a position, in order to maintain objectivity: 112

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“If what I had expected to happen does not happen then I know to get out. Whether I get out at a profit or loss does not matter. As soon as I realise my scenario was wrong I get out. Another easy case is when everything I expected happened, so I take my profits. Those are the two easy cases, and everything in between is difficult.” What Bernard Oppetit is discussing is that all open positions have to be viewed objectively. That means you have to focus on certain questions and reasons and ignore others. You need to focus on these points: • Has what you expected to happen happened? • Are you a buyer or a seller at this price? • Is the probability of what you expected to occur still the same as when you placed the trade? You have to ignore: • How much of a loss you are sitting on. • How much of a profit you are sitting on. • How much you paid for the position. • The fact that the position may turn around. Interview with Pat Arbor

Risk-taking is older than literature. As far back as 3500 BC the Mahabharat, the holy scriptures of the world’s oldest religion, Hinduism, describes a game of chance played with dice on which kingdoms were wagered. Little wonder then, as Peter Bernstein states in Against the Gods (Wiley, 1998): “The modern conception of risk is rooted in the Hindu-Arabic numbering system that reached the West seven to eight hundred years ago.” Dealing with risk is part and parcel of being a trader, and many traders great and small will have their own ideas about risk management. But what precisely is the relationship of the great trader to risk? What would an experienced trader such as Pat Arbor, former Chairman of the Chicago Board of Trade, the world’s largest derivatives exchange, have to say about risk? Risk – why take it?

Pat Arbor puts it like this: “Nobody ever achieved greatness by doing nothing. You have got to step out and do something and take a chance and get your teeth kicked in. A good trader has to engage in some acts which are considered risky.” 113

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As he goes on to explain, great traders take risks and manage risks: “I think a great trader certainly has to have a psychological stability about themselves, but not too much stability, because one has to have a certain flair for risk. It is a fine psychological blend you have got to look for in a trader; the ability to take risk, the ability to have some courage, coupled with stability in the psychological make-up. I think the great traders have to have a greater appetite for risk than the normal person or the poorer traders. Then the question is how they manage that risk, the discipline they impose on themselves to manage that risk. In most cases the risk is balanced. In my own trading I have always tried to be a spreader or arbitrageur. If I am long one month soybeans then I am generally short another month soybeans. And I generally do soybeans or bond spreads. If I am long bonds then I am short 10-year notes. Sometimes if I am long a commodity outright, then I might be long corn and short soybeans or long soybeans and short corn. You also spread because you may not be prepared for the straight position. You may like the position, you may be bullish on the position, and it may not be going well. You would like to maintain your position, possibly moderate it a little, by selling something against it. You may be long soybeans outright, and you can neutralise it a little by selling soybean meal, or soybean oil or some corn against it. Your S&P position may not be going so well and you may want to sell bonds against it.You are keeping your position but cutting your profit potential. Of course, you could just take the loss. But where you may not do that and have a spread instead is where you think you are right and like the position then you tend to neutralize it a little bit to mitigate the loss.” Finding a style to fit

Spreading or hedging as a form of risk management is not necessarily suited to everyone, as Pat Arbor explains: “As a trader you must decide what you are. You are either a speculator, spreader, or local scalper. You have to fit into one of those categories. Me, I am suited to spreading. To find what suits his personality, he just has to see whether or not he makes money at what he’s doing. I have had people come into the office, saying, ‘I am a great trader.’ I say, ‘You’re right,’ they say, ‘Know how to trade.’ I say again, ‘You’re right’ and they say, ‘I predicted that the market was going to go up or down,’ and I say again, ‘You are right. But the bottom line is whether you make any money.’ 114

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So, while hedging can be a good way to manage risk, whether or not you wish to be a hedger depends on what trading style makes money for you given the type of trading personality you are. Progressive trading is the name I have given to the idea that the best trading results and long-term profitability are assured through a ‘slow and steady’ style of trading. I have yet to meet a great trader that advocates wild risks in order to make spectacular home runs.” From small acorns: progressive trading

Pat Arbor continues: “The best traders I think are those who try to make a little bit every day. You surely have your success stories; those that hit home runs, but if you take a record or study of the home run hitters against those that try to hit singles every day, the success rate of the former is a lot less than the latter. So a good trader ends up being one who accumulates capital over a period of time. I remember once explaining this to a young Italian trader and I said to him, it’s una fagiola (one bean) a day. If you try to put one bean in a bag per day, then at the end of the month you are going to have 31 beans in the bag. But if you try to put all 31 beans through the mouth of the bag you will spill a few, and in some cases you will not get any of them in. So, it is better to build it up one day at a time, in a small manner, slowly. It’s tempting not to do that when you see George Soros, but if you live by the trading sword, you die by the trading sword.” Implicit in Pat Arbor’s advice about ‘progressive trading’ is the idea that it is all right to be out of the market: “The discipline not to trade, that’s a big one. A lot of people don’t realize that. A lot of people think you should stand there all day long and be in the market all day long. There are times when the market is so dead or so illiquid that you should not be trading. There are times when the market is terribly volatile and makes no sense and you should not be trading. It is generally the former, though. I have seen people stand there all day long when there is nothing going on, just a few locals in the pit. They will put a position on out of boredom. Then they can’t get out of it easily. I say to them, ‘Well, you shouldn’t be trading. There’s nothing going on. Take it easy. Take a walk. Go off to the coffee shop.” I think I’ll go for a coffee now. Trading is about risk. Risk can be bought and sold like any other commodity. Derivatives are one instrument through which risk is transferred. A great trader 115

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has a deep understanding of the nature of risk, but, perhaps most surprisingly, is risk-averse; he takes out insurance against being wrong. Moreover, he balances risk with his own personality to produce a harmony between the two; never being so exposed as to feel uncomfortable and let it affect his trading. Interview with Jon Najarian

Six feet tall, a muscular physique and bald save for a pony tail – that is Jon Najarian by appearance. In 1989 he formed Mercury Trading, a designated primary market maker, responsible for maintaining a market in stocks for which it had been designated. Two years later, Mercury Trading reported a return on capital of 415%. Today it is the second most active market maker on the Chicago Board Options Exchange (CBOE). As he is a highly profitable trader, I wanted to know what advice he would give to other traders about risk. Risk aversion: ‘Risk not Thine Whole Wad’

As Najarian explains: “I am very risk-averse. You have probably seen on people’s walls, ‘Risk not thine whole wad.’ We always try to position ourselves so that we can always trade tomorrow. That is the single most important thing. Not making money today, making money today, is not more important than being able to come back tomorrow. If I want to be short the market, because I think they are going to raise rates and that will pressure the market, will I be naked short? No, we are long puts and every day that goes by and the market drops, we buy a ton of calls so that if the market turns and goes up we do not lose all the money that we made by being right. You only get so many times a year to be right. But we always want to lock in the profits so we are constantly rolling down out hedge and never just one way long or short. Many days when placing a spread or a hedge, we think, "god, if someone had tied me up in a closet we would have made a fortune, because as the stock was falling we were taking profits all the way down." Well that is just the curse of being a hedger. It is also the reason why we sleep the way we sleep every night.” Because Najarian knows he has disaster protection insurance, he can be more at ease: 116

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“When you come in after a weekend where the market was down 148 points, it looks ugly, they were having trouble finding buyers all day, then if I am stuck in a position I could be very panicked. But we sleep like babies.” Any temptation to go for home runs?

It is comforting to know that the top traders have the same bad trading temptations as the rest of us: “Sure, there are times when we wished that we were not as disciplined. But more times than not we were glad that we were disciplined. We see so many people bet for home runs by putting all their marbles on a big shot. When we bet on a big move we do it with a controlled amount of risk even though we are betting for a home run. We are buying a lot of out-of-the money puts and we are selling out-of-the money puts as well as a hedge against the puts we are buying. If we say we are buying some puts for $4 and selling other puts for $2 then we only have $2 worth of risk. So I can stay at the table twice as long. The other guy, who is unhedged, is starting to gag when the market is going against him, but we can stay with the trade longer.” Since the hedge provides Jon Najarian with a comfort zone, he can be free to exercise clearer judgment. Imagine the last time you were panicked by an adverse price move. Did it ruin your day? Did it plague your mind? Did it affect other trading decisions? If so, have you considered hedging your position? You will, of course, have to examine the cost elements of hedging and the extent you may wish to be hedged. Risk is a beautiful thing, with ingenuity you can purchase or sell just the precise amount of risk: “The other thing we look at is the buyers and sellers. Again, on the derivatives side we see Salomon, Morgan Stanley, Lehman, NatWest buying, buying, buying a certain stock and we know they are betting on the upside, too. So, we are reading all these tea leaves as well. We see that the chart pattern looks good, institutional buyers are coming in – is there anything in the news? Are there earnings coming up, has anybody commented on it favourably, is there a new product coming out, is there a lawsuit pending? We look at all those things so that by the time we actually place the bet we probably have a huge edge because of all those factors we looked at, that our winning percentage is off the charts. Most people do not have the benefit of seeing all that information so what they have to do is give themselves the chance of being as right as possible.” It follows from this that when Jon Najarian does enter a trade he wants the upside to be far greater than the downside, even if the downside move is highly improbable: 117

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“The worst I do is a 1:1 risk reward ratio. Most of the time I want a 2:1 or 3:1 reward to risk ratio. So if I think it could go to $35 then I sell at a loss, if I am wrong at $29 or $28 so that I have a multiple risk reward ratio on the upside. If I am wrong I cut the trade and move on. You cannot be willing to say I am going to ride this stock down to $20 if I am wrong, but I am going to make $5 if I am right. If you do that kind of thing you are just not going to be in business very long. I would never put a multiplier on the risk to the downside. I would never say that although there is $5 on the upside, I am so confident that I am willing to take a $10 risk to the down side. It would not be acceptable risk.” Few people would associate such a risk-averse, belt and braces approach with a trader, let alone a great trader. However, risk aversion and caution are the hallmarks of great traders. While many of us may have a strong appreciation of this, it can never hurt to be reminded. Interview with Bill Lipschutz The equation using other people’s funds

Many traders dream of going it alone and managing money. So what are the pitfalls that a private trader working for himself should be aware of when competing against the institutions? Bill Lipschutz is an institutional investor who went it alone and set up his own company. Lipschutz was Global Head of Currency Trading at Salomon Brothers at the end of the 1980s. If ever there were a right time and a right place for a trader, that was it – then and there. Over the eight years he was there, Bill Lipschitz earned for his employer an average of $250,000 profit each and every trading day. Here is a man who knows his trading. Many traders, armed with their trading plan or strategy, will often hastily and prematurely enter a trade. Their decision is often driven by fear; the fear of the missed opportunity. Their mind will be screaming, ‘Quick get on the trade, you’re going to miss it, so what if all your criteria for entering a trade have not been met? Most of them have, so get on, the big traders wouldn’t hang around.’ The inevitable result is that the trade will not be profitable or not as profitable as it would have been had the trader waited for the precise moment to strike. In trading the fear of the missed opportunity leads to many avoidable losses. And the game of trading is as much about avoiding losses as about capturing profits. The leading traders have a different perspective on opportunity. Counter-intuitively, they know opportunity knocks once, twice, and then kicks the door down. 118

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They know that if this trade does not feel absolutely perfect, there will be another one along in a short while that will. That knowledge alleviates and overrides any fear. That knowledge is the key to unlocking greater profits by waiting for all the trade entry criteria to be met, and not cutting corners. Bill Lipschutz summed it up when he said: “Out of 250 trades in a year, it comes down to five, three of those will be wrong and you will lose a fortune and two will be right and you will make a fortune; for the other 245 trades – you should have been sitting on your hands.” Luck: stacking the odds

Following on from the nature of traders as being risk-averse, they have a knack for stacking the odds. As Lipschutz puts it: “I happen to believe that by far the biggest component of trading success is luck, it’s not the rolling the dice type of luck, but stacking the odds.” These top traders practise their risk aversion by ensuring the odds of a successful outcome are heavily stacked in their favour. This is done not only by ample research and planning, but also by recognising when they are in a good trade and ‘pushing their luck’. As David Kyte, Chairman of the Kyte Group and the largest local on LIFFE put it: “You do not step in the way of a train that’s going at full steam.” Which one of the two trades would put the luck of a return on your side from going long in a stock future? Chart 6.4 – Microsoft [MSFT]

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Najarian and Kyte both said, “You make your own luck in this game”, meaning that you stack the odds of making a profitable trade by planning and waiting until all your trade entry criteria are satisfied. If the trade does prove to be as lucrative as it promised you ‘push your luck’ by perhaps adding to the position and riding it for all it is worth.

The emotional problem Traders’ attitudes to their potential and existing positions are often a great determinant of success. As every trader knows, the moment a trade is executed, everything is different. That is the point at which it becomes real, no longer digits on a screen and numbers in an account. Now expectation is joined by anticipation. The brain is joined by the heart. Reason is joined by emotion. You exchange detachment for attachment. When you have an open position and you are looking to close it, you will either have a profit or a loss. The emotions relating to each are quite different. For instance, when sitting on a loss many traders experience hope that the position will turn around because they fear and deny that it may not. It is for you to recognise these emotions and to discard them. Your judgment has to be based on detached reason relating to your analysis of the company. How you behave once you have an open position is all important. Without clear thinking, you could exit too soon or too late. Your key concern with an open position is timing your exit. Of course, there are times when you are deciding whether to add to a position, but generally you are concerned with exit. With an open position you are concerned with closing the position. In order to do that an open position requires an open mind. As Oppetit puts it: “The key is to be intellectually honest. You have to think of every day as a clean slate. You’ve got to forget about your loss or how much you paid you have to treat each day as a completely new day. You have to start everyday with a blank page. Mark to market should be the rule so you start each day afresh. There is no expected profit or loss on the book so you have to start from scratch each morning.”

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Fig 6.1 – Typical emotional cycle of a trade

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7

Chapter

Directory of Stock Futures Resources • Exchanges • Brokers • Regulators • Industry associations

• Industry information and educational resources • Market information • Other trading services

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Directory of Stock Futures Resources

Exchanges Australia

Sydney Futures Exchange (SFE) www.sfe.com.au

Canada

Bourse de Montreal (Mx) www.m-x.ca

Hong Kong

Hong Kong Exchanges & Clearing (HKEx) www.hkex.com.hk

Hungary

Budapest Stock Exchange (BSE) www.bse.hu

India

National Stock Exchange of India (NSE) www.nse-india.com

Italy

Italian Derivatives Market www.borsaitalia.it

Netherlands

Euronext Amsterdam www.euronext.com

Portugal

Euronext Lisbon www.euronext.com

Singapore

Singapore Exchanges www.simex.sg

South Africa

South African Futures Exchange (SAFEX) www.safex.co.za

Spain

MEFF www.meff.com

Sweden

Stockholmborsen (OM) www.stockholmsborsen.se

United Kingdom

LIFFE www.liffe.com, www.euronext.com

United States

OneChicago www.onechicago.com Nasdaq Liffe Markets (NQLX) www.nqlx.com

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Alpesh B. Patel on Stock Futures

Brokers LIFFE (Designated brokers for USFs on a range of global stocks)

ADM Investor Services GNI Touch ODL Securities Man Direct Sucden (UK)

www.admisi.com www.gnitouch.com www.odlsecurities.com www.mandirect.com www.sucden.co.uk

MEFF (for SSFs on Spanish stocks)

Barclays Bank plc BNP Paribas J.P. Morgan Securities Ltd. Refco Overseas Ltd. Morgan Stanley SV

www.barcap.com www.bnpparibas.es www.jpmorgan.es www.refco.com www.morganstanley.es

NQLX (for SSFs on US stocks)

Interactive Brokers LLC Cargill Investor Services Lind-Waldock Penson Worldwide, Inc. Peregrine Financial Group, Inc.

www.interactivebrokers.com www.cis.cargill.com www.lind-waldock.com www.penson.com www.pfgbest.com

Alaron Trading American Options Services Charles Schwab & Co., Inc. Interactive Brokers LLC Lind-Waldock Peregrine Financial Group, Inc.

www.alaron.com www.aosbroker.com www.schwab.com www.interactivebrokers.com www.lind-waldock.com www.pfgbest.com

OneChicago (for SSFs on US stocks)

126

Directory of Stock Futures Resources

Regulators

United Kingdom Financial Services Authority

www.fsa.gov.uk

United States National Association of Securities Dealers (NASD)

www.nasd.com National Futures Association (NFA)

www.nfa.futures.org Broker education and training; futures broker background information; investor publications. US Commodity Futures Trading Commission (CFTC)

www.cftc.gov Trading basics; futures broker background and registration information; consumer protection and enforcement actions; law and regulation. US Securities and Exchange Commission (SEC)

www.sec.gov Investor publications; securities broker background and registration information; consumer protection and enforcement actions; law and regulation; company filings (EDGAR database).

127

Alpesh B. Patel on Stock Futures

Industry associations Futures Industry Association (FIA)

www.futuresindustry.org Industry publications and events; industry Yellow Pages. The Institute for Financial Markets (IFM)

www.theifm.org Investor education; broker ethics training and exam preparation. Managed Funds Association (MFA)

www.mfainfo.org Industry publications and events; industry Yellow Pages. Securities Industry Association (SIA)

www.sia.com Industry publications and events; professional development and education; investor publications.

128

Directory of Stock Futures Resources

Industry information and educational resources LIFFE’s Universal Stock Futures Service

www.universal-stockfutures.com www.liffeinvestor.com • Free trading simulation game • Free online learning centre • Free live USF prices • Historical data LIFFE’s German USF site

www.liffeinvestor.com/de Chicago Board Options Exchange (CBOE)

www.cboe.com Chicago Mercantile Exchange (CME)

www.cme.com Chicago Board of Trade (CBOT)

www.cbot.com The Options Clearing Corporation (OCC)

www.theocc.com

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Alpesh B. Patel on Stock Futures

Market information Bloomberg

www.bloomberg.com CBS MarketWatch

www.marketwatch.com CNNfn

www.cnnfn.com FT.com

www.ft.com Euronext.liffe

www.liffeinvestor.com www.universal-stockfutures.com www.liffe.com www.euronext.com

Other trading services Note: Similar services generating trading ideas are often available via the brokers themselves. Market-neutral Strategy

www.marketneutralstrategy.com PairsTrading.com

www.pairstrading.com Tradetrek

www.tradetrek.com

130

Appendices a)

Top 15 exchanges worldwide for stock futures trading

b)

List of USFs traded on LIFFE

c)

List of SSFs traded on OneChicago

d)

List of SSFs traded on NQLX

e)

List of SSFs traded on MEFF

f)

List of SSFs traded on NSE

g)

Sample contract specification - LIFFE

h)

Sample contract specification - OneChicago

i)

Sample contract specification - NQLX

131

Alpesh B. Patel on Stock Futures

Top 15 exchanges worldwide for stock futures trading Exchange

Country

NSE India MEFF Euronext LIFFE South African Futures Exchange Helsinki Exchanges OneChicago Stockholmborsen Budapest Stock Exchange Euronext Lisbon Borsa Italiana Australian Stock Exchange Sydney Futures Exchange Euronext Amsterdam Hong Kong Exchanges and Clearing Singapore Exchanges Copenhagen Stock Exchange

India Spain UK South Africa Finland USA Sweden Hungary Portugal Italy Australia Australia Netherlands Hong Kong Singapore Denmark

Source: Futures Industry Association Notes: i)

The above rankings are based on number of stock futures contracts in the year 2003. ii) Most exchanges measure size of contracts differently for the purposes of reporting volumes.

132

Appendices

List of USFs traded on LIFFE USFs on UK Stocks (institutional not retail clients) Company

Abbey National plc AstraZeneca plc Aviva plc Barclays plc BP plc BT Group plc Diageo plc GlaxoSmithKline plc GUS plc HBOS plc HSBC Holdings plc Legal & General Group plc Lloyds TSB Group plc Marks & Spencer plc mmO2 plc Prudential plc Royal Bank of Scotland Group plc Sainsbury (J) plc Shell Transport & Trading Co plc Tesco plc Unilever plc Vodafone Group plc

LIFFE Code

ABN AZN CGN BAR BPA BTL DGE GXW GSU HBO HSA LGN LLO MKS MMO PUR RBO SBR SHE TSC ULR VOF

133

Alpesh B. Patel on Stock Futures

USFs on US stocks Company

LIFFE Code

Amgen Inc AOL Time Warner Inc Cisco Systems Inc Exxon Mobil Corp General Electric Company IBM Corporation Intel Corp Merck & Co. Inc Microsoft Corp Pfizer Inc Wal-Mart Stores Inc

AMG AOL CSC XOM GE IBM INT MRK MSF PFE WMT

USFs on Continental European stocks

*signifies that USF contracts are physically delivered

Company

LIFFE Code

Country

Danske Bank A/S* Novo-Nordisk A/S* Nokia OYJ* Stora Enso OYJ* UPM-Kymmene OYJ* Accor SA Air Liquide SA Alcatel SA Arcelor Aventis SA Axa SA BNP Paribas SA Bouygues SA Carrefour SA

DNX NNX NOX STX UPX AC AI CGE LOR AVE AXA BNP EN CA

Denmark Denmark Finland Finland Finland France France France France France France France France France

134

Appendices

USFs on Continental European stocks contd.

Compagnie de Saint Gobain Credit Agricole SA France Telecom SA Groupe Danone SA Lafarge SA Lagardere SCA L’Oréal SA LVMH SA Pernod Ricard SA Peugeot SA Pinault-Printemps-Redoute SA Renault SA Sanofi-Synthelabo SA Schneider Electric SA Societe Generale SA Societe Television Francaise (T.F.I) Suez SA Total SA Vivendi Universal SA Allianz AG BASF AG Bayer AG Bayerische Hypo-und Vereinsbank Bayerische Motoren Werke (BMW) Commerzbank AG DaimlerChrysler AG Deutsche Bank AG Deutsche Post AG Deutsche Telekom AG E.ON AG Hypo Real Estate Holding AG Infineon Technologies AG Metro AG Münchener Rückversicherungs G.

SGO ACA FTE BN LG MMB OR MC RI UG PP RNO SSL SU GLE TFI SZE TOT VIV ALV BAS BYR HVB BMW CBK DCY DBK DPW DTE EOA HRH IF MEO MUV

France France France France France France France France France France France France France France France France France France France Germany Germany Germany Germany Germany Germany Germany Germany Germany Germany Germany Germany Germany Germany Germany 135

Alpesh B. Patel on Stock Futures

RWE AG SAP AG Schering AG Siemens AG Volkswagen AG Assicurazioni Generali SpA Banca Intesa SpA Banco Popolare Di Verona E Novara Capitalia SpA Enel SpA Eni SpA Fiat SpA MediaSet SpA Mediobanca SpA Riunione Adriatica di Sicurta SpA San Paolo-IMI SpA STMicroelectronics NV Telecom Italia Mobile SpA Telecom Italia SpA (saving shares) Telecom Italia SpA UniCredito Italiano SpA ABN AMRO Holdings NV Aegon NV Akzo Nobel NV Fortis Heinekien NV ING Groep NV Koninklijke Ahold NV Koninklijke KPN NV Koninklijke Philips Electronics NV Reed Elsevier Royal Dutch Petroleum Co TPG NV Unilever NV VNU NV 136

RWE SAP SHC SIE VOW GEN BIN BPV CAT ENL ENI FIA MSI MB RAS SPI STM TIM TIR TI UC AA AGN AKZ FOR HEI ING AHL KPN PHI REN RD TPG UNA VNU

Germany Germany Germany Germany Germany Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Italy Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands Netherlands

Appendices

Norsk Hydro ASA* Altadis SA Banco Bilbao Vizcaya Argentaria SA Banco Popular Espanol SA Endesa SA Iberdrola SA Industria de Diseno Textil SA Repsol YPF SA Santander Central Hispano SA Telefonica Moviles SA Telefonica SA Terra Networks SA Hennes & Mauritz AB Nordea AB Svenska Handelsbanken Telefonaktiebolaget LM Ericsson TeliaSonera AB Credit Suisse Group Nestle SA Novartis AG Roche Holding AG Swiss Reinsurance AG Swisscom AG UBS AG Zurich Financial Services AG

NHX ALT BVA POP ELE IBE IT REP SCH TEM TEF TRR HNM NDA SHB ERC TLI CSG NES NOV ROG RUK SCM UBS ZUR

Norway Spain Spain Spain Spain Spain Spain Spain Spain Spain Spain Spain Sweden Sweden Sweden Sweden Sweden Switzerland Switzerland Switzerland Switzerland Switzerland Switzerland Switzerland Switzerland

137

Alpesh B. Patel on Stock Futures

List of SSFs traded on OneChicago Company

3M Co. Alcoa Inc. Altera Corp. Altria Group Inc. Amazon.com Inc. American Express Co. American International Group Amgen Inc. AOL Time Warner Inc. Applied Materials Inc. AT&T Corp Bank of America Corp. Bank One Best Buy Company Inc. Biogen Inc. Boeing Co. Bristol-Myers Squibb Co. Broadcom Corp. - CLA Brocade Communications Sys Caterpillar Inc. Cephalon Inc. Check Point Software Tech ChevronTexaco Corp. Cisco Systems Inc. Citigroup Inc. Coca-Cola Co. Dell Inc. Dow Chemical Co. DuPont (E.I. Du Pont de Nemours) Eastman Kodak eBay Inc. 138

Stock Ticker Symbol

OneChicago Base Symbol

MMM AA ALTR MO AMZN AXP AIG AMGN AOL AMAT T BAC ONE BBY BGEN BA BMY BRCM BRCD CAT CEPH CHKP CVX CSCO C KO DELL DOW DD EK EBAY

MMM1C AA1C ALTR1C MO1C AMZN1C AXP1C AIG1C AMGN1C AOL1C AMAT1C T1C BAC1C ONE1C BBY1C BGEN1C BA1C BMY1C BRCM1C BRCD1C CAT1C CEPH1C CHKP1C CVX1C CSCO1C C1C KO1C DELL1C DOW1C DD1C EK1C EBAY1C

Appendices

Emulex Corp. Exxon Mobil Corp. Ford Motor Co. General Electric Co. General Motors Corp. Genzyme Corp. - Genl Division Goldman Sachs Group Inc. Halliburton Co. Hewlett-Packard Co. Home Depot Inc. Honeywell International Inc. Idec Pharmaceuticals Corp. Intel Corp. International Business Machines Corp. International Paper Co. J.P. Morgan Chase & Co. Johnson & Johnson KLA-Tencor Corp. Krispy Kreme Doughnuts Inc. Linear Technology Corp. Lowe’s Cos. Inc. Maxim Integrated Products Inc. McDonald’s Corp. Merck & Co. Inc. Merrill Lynch & Co. Inc. Micron Technology Inc. Microsoft Corp. Morgan Stanley Motorola Inc. Newmont Mining Corp Hldg Co. Nextel Communications Inc. Nokia Corp. ADR Northrop Grumman Corp. Novellus Systems Inc. NVIDIA Corp.

ELX XOM F GE GM GENZ GS HAL HPQ HD HON IDPH INTC IBM IP JPM JNJ KLAC KKD LLTC LOW MXIM MCD MRK MER MU MSFT MWD MOT NEM NXTL NOK NOC NVLS NVDA

ELX1C XOM1C F1C GE1C GM1C GENZ1C GS1C HAL1C HPQ1C HD1C HON1C IDPH1C INTC1C IBM1C IP1C JPM1C JNJ1C KLAC1C KKD1C LLTC1C LOW1C MXIM1C MCD1C MRK1C MER1C MU1C MSFT1C MWD1C MOT1C NEM1C NXTL1C NOK1C NOC1C NVLS1C NVDA1C 139

Alpesh B. Patel on Stock Futures

Oracle Corp. PeopleSoft Inc. PepsiCo Inc. Pfizer Procter & Gamble Co. QLogic Corp. QUALCOMM Inc. SanDisk Corp. SBC Communications Inc. Schlumberger Ltd Siebel Systems Inc. Starbucks Corp. Sun Microsystems Symantec Corp. Texas Instruments Inc. Tyco International Ltd United Technologies Corp. VERITAS Software Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co. Wells Fargo & Co. Xilinx Inc. Yahoo! Inc.

ORCL PSFT PEP PFE PG QLGC QCOM SNDK SBC SLB SEBL SBUX SUNW SYMC TXN TYC UTX VRTS VZ WMT DIS WFC XLNX YHOO

ORCL1C PSFT1C PEP1C PFE1C PG1C QLGC1C QCOM1C SNDK1C SBC1C SLB1C SEBL1C SBUX1C SUNW1C SYMC1C TXN1C TYC1C UTX1C VRTS1C VZ1C WMT1C DIS1C WFC1C XLNX1C YHOO1C Source: OneChicago www.onechicago.com

140

Appendices

List of SSFs traded on NQLX Company Name

Exchange

Advanced Micro Devices Altria Group, Inc. American Express Co. American International Grp. Amgen, Inc. Apple Computer, Inc AT&T Corp. Bank of America Corp. Barrick Gold Corp. Bed Bath & Beyond Inc. Best Buy Co., Inc. Broadcom Corp. Cendant Corp. ChevronTexaco Corp. CIENA Corp. Cisco Systems, Inc. Citigroup, Inc. Coca-Cola Co. Comverse Technology Inc. Dell Computer Corp. eBay, Inc. El Paso Corporation Exxon Mobil Corp. Ford Motor Co. General Electric Co. General Motors Corp. Genzyme Corp Hewlett-Packard Co. Home Depot, Inc. Intel Corp. International Bus. Machines Johnson & Johnson

NYSE NYSE NYSE NYSE NASDAQ NASDAQ NYSE NYSE NYSE NASDAQ NYSE NASDAQ NYSE NYSE NASDAQ NASDAQ NYSE NYSE NASDAQ NASDAQ NASDAQ NYSE NYSE NYSE NYSE NYSE NASDAQ NYSE NYSE NASDAQ NYSE NYSE

Underlying Ticker

NQLX

AMD MO AXP AIG AMGN AAPL T BAC ABX BBBY BBY BRCM CD CVX CIEN CSCO C KO CMVT DELL EBAY EP XOM F GE GM GENZ HPQ HD INTC IBM JNJ

AMD MO AXP AIG AMG APL T BAC ABX BBB BBY BRC CD CVX CIE CSC C KO CMV DEL EBA EP XOM F GE GM GEN HPQ HD INT IBM JNJ

Sector

Mnemonic1

Semiconductors Agriculture Fin. Services Insurance Biotechnology Computers Telecons Banks Mining Retail Retail Semiconductors Commercial Svcs.

Oil & Gas Telecom Equip. Telecoms Fin. Services Beverages Telecoms Computers Internet Oil & Gas Oil & Gas Auto Manuf. Misc. Manuf. Auto Manuf. Biotechnology Computers Retail Semiconductors Computers Healthcare 141

Alpesh B. Patel on Stock Futures

JP Morgan Chase & Co. Juniper Networks Inc. Kla-Tencor Corp. Maxim Integrated Products. Merck & Co., Inc. Merrill Lynch & Co., Inc. Microsoft Corp. Motorola Inc. Newmont Mining Corp. Nokia Corporation ADR Novellus Systems, Inc. Nvidia Corp. Oracle Corp. Pepsico, Inc. Pfizer, Inc. Qlogic Corp. QUALCOMM, Inc. SBC Communications, Inc. Schering-Plough Corp. Texas Instruments, Inc. Veritas Software Corp. Verizon Communications Wal-Mart Stores, Inc. Yahoo!, Inc.

NYSE NASDAQ NASDAQ NASDAQ NYSE NYSE NASDAQ NYSE NYSE NYSE NASDAQ NASDAQ NASDAQ NYSE NYSE NASDAQ NASDAQ NYSE NYSE NYSE NASDAQ NYSE NYSE NASDAQ

JPM JNPR KLAC MXIM MRK MER MSFT MOT NEM NOK NVLS NVDA ORCL PEP PFE QLGC QCOM SBC SGP TXN VRTS VZ WMT YHOO

JPM JNP KLA MXI MRK MER MSF MOT NEM NOK NVL NVD ORC PEP PFE QLG QCO SBC SGP TXN VRT VZ WMT YHO

Fin. Services Networking Semiconductors Semiconductors Pharmaceuticals

Fin. Services Software Communications

Mining Telecoms Semiconductors Semiconductors Software Beverages Pharmaceuticals

Semiconductors Telecoms Telecoms Pharmaceuticals

Semiconductors Computers Telecoms Retail Internet

Source: NQLX www.nqlx.com

For an up to date list of USFs visit: www.universal-stockfutures.com/list.aspx

142

Appendices

List of SSFs traded on MEFF Company BBVA Endesa Iberdrola Inditex Repsol YPF SCH Telefonica Moviles Telefonica Terra

Source: MEFF www.meff.com

143

Alpesh B. Patel on Stock Futures

List of SSFs traded on National Stock Exchange of India Company

Symbol

Associated Cement Co. Ltd Andhra Bank Arvind Mills Ltd Bajaj Auto Ltd Bank of Baroda Bank of India Bharat Electronics Ltd Bharat Heavy Electricals Ltd Bharat Petroleum Corporation Ltd BSES Ltd Canara Bank Cipla Ltd. Digital Globalsoft Ltd Dr. Reddy’s Laboratories Ltd Gas Authority of India Ltd Grasim Industries Ltd Gujarat Ambuja Cement Ltd HCL Technologies Ltd Housing Development Finance Corporation Ltd HDFC Bank Ltd. Hero Honda Motors Ltd Hindalco Industries Ltd Hindustan Lever Ltd Hindustan Petroleum Corporation Ltd ICICI Bank Ltd I-FLEX Solutions Ltd Infosys Technologies Ltd Indian Petrochemicals Corpn. Ltd Indian Oil Corporation Ltd ITC Ltd Larsen & Toubro Ltd Mahindra & Mahindra Ltd Maruti Udyog Ltd

ACC ANDHRABANK ARVINDMILL BAJAJAUTO BANKBARODA BANKINDIA BEL BHEL BPCL BSES CANBK CIPLA DIGITALEQP DRREDDY GAIL GRASIM GUJAMBCEM HCLTECH HDFC HDFCBANK HEROHONDA HINDALC0 HINDLEVER HINDPETRO ICICIBANK I-FLEX INFOSYSTCH IPCL IOC ITC L&T M&M MARUTI

144

Appendices

Mastek Ltd Mahanagar Telephone Nigam Ltd National Aluminium Co. Ltd NIIT Ltd Oil & Natural Gas Corp. Ltd Oriental Bank of Commerce Polaris Software Lab Ltd Punjab National Bank Ranbaxy Laboratories Ltd Reliance Industries Ltd Satyam Computer Services Ltd State Bank of India Shipping Corporation of India Ltd Syndicate Bank Tata Power Co. Ltd Tata Tea Ltd Tata Engineering and Locomotive Co. Ltd Tata Iron and Steel Co. Ltd Union Bank of India Wipro Ltd

MASTEK MTNL NATIONALUM NIIT ONGC ORIENTBANK POLARIS PNB RANBAXY RELIANCE SATYAMCOMP SBIN SCI SYNDIBANK TATAPOWER TATATEA TELCO TISCO UNIONBANK WIPRO

Source: National Stock Exchange of India (NSE) www.nse-india.com

145

Alpesh B. Patel on Stock Futures

146

Appendices

Sample contract specifications - LIFFE Note: Unless otherwise indicated, all times are London times.

USFs (cash settlement) on Continental European Shares Unit of Trading

One future normally represents 100 shares, except for Italian futures where one future normally represents 1,000 shares.

Delivery Months

Nearest two of March, June, September and December, plus nearest two serial months such that the nearest three calendar months are always available for trading .

Quotation

Euro per share Sweden SEK per share Switzerland CHF per share

Minimum Price Movement (Tick Size)

€0.01 Sweden SEK 0.01 Switzerland CHF 0.1 or CHF 0.05*

Tick Value

€1.00 Italy €10 Sweden SEK 1.00 Switzerland CHF 10 or CHF 5*

Last Trading Day

Germany, Netherlands, Spain, Sweden, Switzerland: third Friday of the delivery month France: Penultimate business day of delivery month•• Italy: Business day immediately preceding the third Friday of the delivery month

Settlement Day

France, Germany, Netherlands, Spain, Sweden, Switzerland: First business day following the Last Trading Day Italy: Two business days following the Last Trading Day France, Germany, Italy, Netherlands, Spain, Sweden, Switzerland: 08:00-17:30, Last Trading Day 08:00 - 16:30

Trading Hours

* Credit Suisse Group, Novartis AG and UBS AG •• For all delivery months from October 2004 onwards the last trading day will be the third Friday of the delivery month.

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Alpesh B. Patel on Stock Futures

Please check websites for the very latest information as settlement dates are planned to change in 2004. Trading Platform

• LIFFE CONNECT® Trading Host for Futures and Options • Algorithm: Central order book applies a price-time trading algorithm with priority given to the first order at the best price. • Wholesale Trading Facilities: Asset Allocation, Block Trading, Basis Trading Exchange Delivery Settlement Price (EDSP)

France Germany Italy

– – –

Netherlands Spain Sweden Switzerland

– – – –

Official closing price on Euronext Paris Official closing price on Deutsche Börse Opening auction price on Borsa Italiana on 3rd Friday of the Delivery month Official closing price on Euronext Amsterdam Official closing price on Bolsa de Madrid Official closing price on Stockholmsborsen Official closing price on virt-x

Contract Standard

Cash settlement based on Exchange Delivery Settlement Price. Source: LIFFE www.liffe.com

148

Appendices

2. USFs (physical delivery) on Continental European Shares

Unit of Trading

One future normally represents 100 shares

Delivery Months

Nearest two of March, June, September and December, plus nearest two serial months such that the nearest three calendar months are always available for trading

Quotation

Denmark DKK per share Euro per share Norway NOK per share

Minimum Price Movement (Tick Size)

€0.01 Denmark DKK 0.5 Norway NOK 0.5

Tick Value

€1.00 Denmark DKK 50 Norway NOK 50

Last Trading Day

Denmark, Finland: third Friday of the delivery month Norway: third Thursday of the delivery month

Settlement Day

Denmark, Finland, Norway: Fourth business day following the Last Trading Day

Trading Hours

Denmark, Finland: 08:00 - 17:30, Last Trading Day 08:00 - 16:00 Norway: 08:00 - 17:30 (London Time), Last Trading Day 08:00 - 15:00 (London Time)

Trading Platform

• LIFFE CONNECT® Trading Host for Futures and Options • Algorithm: Central order book applies a price-time trading algorithm with priority given to the first order at the best price • Wholesale Trading Facilities: Asset Allocation, Block Trading, Basis Trading

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Alpesh B. Patel on Stock Futures

Exchange Delivery Settlement Price (EDSP)

Denmark

–

Finland

–

Norway

–

VWAP of trades during the last 10 minutes of trading on Copenhagen Exchanges VWAP of trades during the last 10 minutes of trading on Helsinki Exchanges Official closing price on Oslo Exchange

Contract Standard

Delivery will be 100 shares (or other such number of shares as determined by the terms of the contract). Source: LIFFE www.liffe.com

3. USFs (cash settlement) on UK Shares

Unit of Trading

One future normally represents 1,000 shares

Delivery Months

Nearest two of March, June, September, December, plus nearest two serial months such that the nearest three calendar months are always available for trading

Last Trading Day

Third Wednesday of the delivery month

Settlement Day

First business day following the last trading day

Quotation

pence per share

Minimum Price Movement (Tick Size)

0.5 pence 0.25 pence**

Tick Value

£5.00 £2.50 **

Trading Hours

08:00 - 17:00 (London time), Last Trading Day 08:00 - 16:30 (London time)

** Vodafone Group plc Universal Stock Futures Contracts minimum price movement has been reduced to 0.25 pence from 0.5 pence with effect from Monday 20 May 2002. 150

Appendices

The following Universal Stock Futures Contracts minimum price movement have been reduced to 0.25 pence from 0.5 pence with effect from 11th November 2002: • • • • • • • •

BT Group plc (BTL) Legal & General Group plc (LGN) Marks & Spencer Group plc (MKS) mmO2 plc (MMO) Sainsbury (J) plc (SBR) Tesco plc (TSC) Barclays (BAR) Shell Transport & Trading Co plc (SHL)

For all delivery months from January 2004 the last trading day will be the 3rd Friday of the delivery month. Trading Platform

• LIFFE CONNECT® Trading Host for Futures and Options • Algorithm: Central order book applies a price-time trading algorithm with priority given to the first order at the best price. • Wholesale Trading Facilities: Asset Allocation, Block Trading, Basis Trading Exchange Delivery Settlement Price (EDSP)

Official closing price on London Stock Exchange. Contract Standard

Cash settlement based on Exchange Delivery Settlement Price. Source: LIFFE www.liffe.com

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Alpesh B. Patel on Stock Futures

4. USFs (cash settlement) on US Shares

Unit of Trading

One future normally represents 100 shares

Delivery Months

Nearest two of March, June, September and December, plus nearest two serial months such that the nearest three calendar months are always available for trading US Dollars per share

Quotation

Minimum Price $0.01 ($1) Movement (Tick Size & Value) Last Trading Day

Third Friday of the delivery month

Settlement Day

First business day following the Last Trading Day

Trading Hours

08:00 - 18:00

Last Trading Day

08.00 - 14.40

Trading Platform

• LIFFE CONNECT® Trading Host for Futures and Options • Algorithm: Central order book applies a price-time trading algorithm with priority given to the first order at the best price. • Wholesale Trading Facilities: Asset Allocation, Block Trading, Basis Trading Exchange Delivery Settlement Price (EDSP)

VWAP of trades on the New York Stock Exchange (NYSE), or the NASDAQ Stock Market, as the case may be, during the first 10 minutes of trading. Contract Standard

Cash settlement based on Exchange Delivery Settlement Price. Source: LIFFE www.liffe.com

152

Appendices

Sample contract specifications OneChicago Contract Size

100 shares of underlying security

Minimum Price Fluctuation (Tick Size)

$0.01 x 100 shares = $1.00

Regular Trading Hours for SSFs Regular Trading Hours for Futures on DIAMONDS ETF

8:15 a.m. - 3:00 p.m. Central Time

Position Limits

Apply only during the last five trading days prior to expiration: Either 13,500 net contracts or 22,500 net contracts as required by CFTC regulations

Daily Price Limits

None

Reportable Position Level

200 Contracts

Contract Months

Two quarterly expirations and two serial months trade at all times for a total of four expirations per product class. OneChicago follows the quarterly cycle of March (H), June (M), September (U), and December (Z). The serial months traded are the two nearest months that are not quarterly expirations.

Expiration Date / Last Trading Day

Third Friday of contract month or, if such Friday is not a business day, the immediately preceding business day.

Settlement / Delivery

Physical delivery of underlying security on third business day following the Expiration Day.

Depository for Underlying Security

DTCC

8:15 a.m. - 3:15 p.m. Central Time

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Alpesh B. Patel on Stock Futures

Additional Information Margin Requirements

Initial and maintenance margin requirement of 20% of the cash value of the contract. Certain offsets may apply

Short Sale Advantages

No uptick required to initiate a short position. No stock borrowing costs or risks.

Clearing and Settlement

Trades executed at OneChicago are cleared and settled by the Options Clearing Corporation (OCC) or by Chicago Mercantile Exchange Inc. (CME).

US Government Regulator

OneChicago is jointly regulated by the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC).

Source: OneChicago www.onechicago.com

154

Appendices

Sample contract specifications - NQLX Nominal Contract Size

100 shares of the common stock or American Depository Receipts (ADRs) of selected companies whose shares are listed on US securities exchanges (i.e. NYSE) or trade over-the-counter (i.e. NASDAQ).

Quotation

US Dollars per share

Minimum Tick Increment

$0.01 per share = $1 per contract

Delivery Months

The first five quarterly delivery months in a March, June, September, and December cycle as well as the nearest two serial months i.e. January and February in December. This will insure that the first three calendar months will always be available for trading.

Symbols

Three character alpha-numeric product code.

Trading Hours

09:30 – 16:00 ET

First Trading Day

The first trading day of a contract is the first business day following the last trading day.

Last Trading Day

The last day of trading on an expiring Security Futures Contract is the third Friday of the delivery month. In the event that the third Friday of the delivery month is not a business day, the last day of trading shall be the business day immediately prior to the third Friday of the month.

Settlement Day and Time

10:00 ET on the next business day following the last trading day.

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Alpesh B. Patel on Stock Futures

Settlement Price Calculation

NQLX will calculate the Daily Settlement Price based on reported prices in the two minute period prior to the time specified for the contract settlement. The first 90 seconds of the Settlement Period will be used to monitor spread levels. The Settlement Price will be determined during the final 30 seconds of the Settlement Period, according to the following criteria: a) If a single trade occurs during the last 30 seconds of the Settlement Period, then the Settlement Price will be the price of that trade. b) If more than one trade occurs during the last 30 seconds of the Settlement Period, then the Settlement Price will be the volume weighted average of the prices of the trades, rounded to the nearest price increment. c) If no trade occurs during the last 30 seconds of the Settlement Period, then the Settlement Price will be calculated as the midway between the active bids and offers at the time the Settlement Price is calculated, rounded to the nearest minimum price increment. d) If there is neither a trade nor active bids and offers during the last 30 seconds of the Settlement Period, then the Settlement Price will be the Settlement Price of the first quarterly delivery month increased or decreased by the latest observed calendar spread differential between the first quarterly delivery month and the relevant contract month. e) Notwithstanding a) through d) above, NQLX may, in its sole discretion, establish a Settlement Price that is a fair and appropriate reflection of the market. But, in arriving at the Settlement Price pursuant this provision, NQLX will, among other factors, consider criteria a) through d) above.

156

Appendices

Delivery Size

Physical delivery of 100 shares (plus or minus the impact of corporate events per standard Options Clearing Corporation (OCC) rules and practices) made through Depository Trust Clearing Corporation (DTCC).

Delivery Process Date

Delivery will be carried out via the DTCC and three-day delivery process. Three business days following the last trading day for the futures (T+3), holders of net short positions deliver the underlying securities to holders of net long positions and payments of the settlement amounts are made. Generally, the underlying stock certificates are stored with the DTCC where book entries are used to move securities between accounts. The net financial obligations for settlement are made, via wire transfers with designated banks, in single payments from the DTCC to firms with net credit positions and to the DTCC from firms with net debit positions. These transactions are cleared through the DTCC before 13:00 ET on the settlement date.

EDSP Calculation (Exchange Delivery Price)

The official closing price of the underlying stock on the NASDAQ or NYSE, as of the Settlement latest possible period before NQLX system closing time (16:30 ET).

Price Limits

There are no daily price limits on Single Stock Futures. When the underlying shares cease to trade in the cash market, the Single Stock Futures based on the underlying will also cease trading in a manner coordinated with the applicable securities exchange.

Reportable Position Limits

200 contracts, equivalent to 20,000 shares of the underlying common stock/ADR. NQLX may introduce different reportable position limits for futures positions held within one month of the last trading date.

Source: NQLX www.nqlx.com 157

Glossary Accumulation

A technical analysis term describing a stock whose price is moving sideways. Acid test ratio

A measure of financial strength. Also known as the quick ratio. Cash plus short-term investments plus accounts receivable divided by current liabilities for the same period. All other things being equal, a relatively high figure may indicate a healthy company. Active market

Securities trading with a relatively high degree of liquidity, the major benefit of which is narrow spreads. A term of art rather then precision. Aftermarket

Also known as secondary market, referring to the trading in a security after its initial public offering. All or none

Order instructing the broker to buy or sell the entire amount of the order in one transaction or not at all. Alpha capture

This is the spread trade between a stock future and a stock index future. The trading is trying to capture alpha – that part of a stock’s return that is attributable to the stock individually as opposed to attributable to the movement of the overall market. For instance, a trader may feel that although the index will rise 5% in the next month, a constituent of the index, such as Vodafone, will rise 7%. American depositary receipt (ADR)

Effectively like owning in dollars stocks of non-US-listed companies. A popular form of owning shares of foreign companies. American Stock Exchange (AMEX)

Located in New York, this is the third-largest US stock exchange. Shares trade in the same ‘auction’ manner used by the larger New York Stock Exchange (NYSE) unlike the NASDQ’s ‘market-making’ methods. Arbitrage

The purchase in one market of an instrument and the sale in another market of the same or a closely-linked instrument in order to profit from the small price differentials between the products in the two markets. Arbitrage profits usually only exist for a small time because someone usually scoops on them since they are ‘locked in’. 159

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Arbitrageur

A trader engaged in arbitrage. They seek to make a lot of small, quick profits. Ask

The lowest price at which a dealer or market maker will sell a security (also, bid, offer). At the close

Order instructing to be filled as close as possible to the close of a particular security, or otherwise to be cancelled. At the market

An order to buy or sell at the best price obtainable in the market. At the open

Order instructing the transaction to be filled in one of the first trades for a particular security, or otherwise to be cancelled. Averaging

Where a price moves against a trader and he trades more of the stock to enlarge his position but to lower his overall entry price. It will mean he will have a lower exit price at which he can make a profit. Away from the market

Trade orders that cannot be executed because they are above or below the current bid or ask. For example, a limit order to buy 50 shares of AOL at $105 when the best offer is $109 will not be filled and is said to be ‘away from the market’. Back month

The futures or options months being traded that are furthest from expiration. Basis

This is the difference between the current cash price and the futures price of the same security. The basis is determined by the costs of actually holding the security versus contracting to buy it for a later delivery (i.e. a futures contract). The basis is affected by influences such as unusual supply or demand. Basis point

Used to calculate differences in interest rate yields, e.g. the difference between 5.25% and 6.00% is 75 basis points. Bear(ish)

An individual who thinks prices will fall. Bear market

A market in which prices are falling.

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Glossary

Beta

This measure a stock’s volatility to the market as a whole. A beta value greater than 1.0 represents greater volatility than the general market; less than 1.0 represents less volatility than the general market. Bid

An offer to purchase at a specific price. Big Board

Nickname for the New York Stock Exchange (NYSE). Block

A transaction involving a large number of shares or other security, as in ‘the sale of a block of shares.’ Often blocks are bought or sold at a discount to the current market as an accepted cost of trading a large number of shares. Breadth

Comparison of issues traded on a stock exchange on a given day to the total number of issues listed for trading. The broader a market move the more significant it is. Break

A sudden fall in price. Breakout

When the price moves out of its recent range. Sometimes signals further moves in the direction of the breakout. Broker

An individual who executes customers’ orders. Bull(ish)

An individual who believes prices will rise. Bull market

A market in which prices are rising. Buy in

A person having to buy a security because of an inability to deliver the shares from a previous sale of said shares. Often associated with short sellers. Buy OCO

Two instructions for a buy order; the execution of either will result in the cancellation of the other. Normally this is where a trader is not sure whether the price will rise or fall, but feels that once it does either he wants to trade in that direction. Buy on opening

An order to buy at the start of trading within the opening price range. 161

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Cash flow per share

The trailing 12-month cash flow divided by the 12-month average shares outstanding. All other things being equal, a relatively high figure, growing steadily, is sign of a growing and healthy company and may indicate a rising share price. Cash price

In stock futures this is the price of the underlying stock that a futures contract is based upon. Cash settlement

The receipt of money in lieu of the contract’s underlying commodity to fulfill the delivery requirements of the futures contract. Those futures that are physically delivered are not subject to a cash settlement. Churning

Illegal practice by a broker to cause excessive transactions in a client’s account which benefit the broker through increased transaction fees. Clearing

The process of recognising that a trade has occurred, and paying for and receiving payment for securities after they have been traded. The process of clearing is generally handled by a central entity, the ‘clearing house’. Closed

When referring to a position this means one has made an equal and opposite trade to one already held and so has no more exposure to the market on that trade. Contract month

Month in which a given contract becomes deliverable, if not liquidated or offset before the date specified. The same as delivery month. Contract size

The number of shares of the underlying security represented by the futures contract. Contrarian

An individual who generally believes it is usually better not to do what the majority is doing, because the majority does not make money. Cost to carry

For physical commodities like coffee, this is the cost of storage space, insurance, and finance charges incurred by holding a physical commodity. In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost necessary to buy the instrument.

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Glossary

Crossed market

The highest bid is greater than the lowest offer due to buyer and seller imbalance. Usually only lasts a few seconds until the market ‘sorts itself out’. Current ratio

The ratio of total current assets divided by the total current liabilities for the same period. A measure of financial strength. All other things being equal, a relatively high figure would indicate a healthy company. Daisy chain

Creating the illusion of trading activity in a stock through collusion of a number of brokers. Yes, it is illegal. Day-trade(r)

A position that is closed the same day it was opened. Deep discount

Often, internet brokers that charge commissions far less than full service or discount brokers; as cheap as you can get. Delivery Month

The month during which a futures contract can be fulfilled. The same as contract month. Depreciation

An accounting measure used to reduce the value of capital expenditure for the purposes of reclaiming tax. Diversification

Reducing risk by spreading investments among different investments. Not putting all your eggs in a few baskets. Dividend ex-date

This is the date from which a purchaser of the stock will not be entitled to receive the last announced dividend. Appropriately, when a stock goes exdividend its price falls by approximately the value of the dividend. Dividend growth rate

A measure of corporate growth. The annual positive change in dividend paid to stockholders. All other things being equal, an increase should indicate a growing company and should be reflected in rising share price. Dividend rate

This is the total expected dividends for the forthcoming twelve months. It is usually the value of the most recent dividend figure multiplied by the number of times dividends are paid in a year, plus any extra dividend payments.

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Dividend yield

This is calculated by dividing the annual dividend by the current price and expressing the figure as a percentage. Down tick

A trade in a security that was executed at a lower price than the previous trade (same as minus tick). EPS

Earnings Per Share. A measure of corporate growth. The value of corporate earnings divided by the number of shares outstanding. All other things being equal, a growing figure reflects a healthy growing company and should be reflected in the share price. Expiration date

The Maturity Date of a contract. The last day a futures contract can trade prior to final settlement. In reality, future contracts do not ‘expire’; a position (long or short) in a futures contract must either be offset by assuming an inverse position in the same contract, or by going through the delivery process. Also called Last Trading Day. Flat

1) A market where the price of a stock and/or its volume have not changed significantly over a period of time; 2) to no longer hold a position in a particular security or account. Floor broker

A member who executes orders for clearing members. Floor trader

An individual who trades on the floor of an exchange either for himself or a company. Freeriding

Rapid buying and selling of a security by a broker without putting up funds for the purchase. Yes, it is illegal. Front running

Buying or selling securities ahead of a large order so as to benefit from the subsequent price move. Fundamental analysis

Forecasting prices by using economic or accounting data. For example, one might base a decision to buy a stock on its yield. Futures

A standardised contract for the future delivery of goods, at a pre-arranged date, location and price. 164

Glossary

Gap

Where a price opens and trades higher than its previous close. Gross margin

A measure of company profitability. The previous twelve month total revenue less cost of goods sold divided by the total revenue. All other things being equal, a decrease in gross margins could indicate troubled times ahead. Hedge

Protection against current or anticipated risk exposure, usually through the purchase of a derivative. For example, if you hold Euros and fear that the price will decline in relation to the dollar you may go long Dollar. You would then make some profit on your long position to offset your losses in holding Euros. Hit the bid

When a seller places market orders with the intention of selling to the highest bidder, regardless of price. In and out

Term for day-trading in a security. Initial margin requirement

Amount of cash and securities a customer must have in his/her account before trading on margin. Initial public offering (IPO)

First sale of stock by a company to the public. Insider

Person such as a corporate officer or director with access to privileged company information. Insider share purchases

The number of shares in the company purchased by its insiders – officers and directors – over a stated period of time. All other things being equal, a relatively large move may indicate a forthcoming upward move in the stock price. Institutional net shares purchased

This is the difference between institutional share purchases less institutional share sales in the company over a stated period of time. All other things being equal, a relatively large move may indicate a forthcoming upward move in the stock price. Institutional percent owned

This is the percentage of shares owned by all the institutions taken together. It is a percentage of the total shares outstanding. All other things being equal, a relatively large move may indicate a forthcoming upward move in the stock price. 165

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Level I quotes

Basic service of the stock market that displays current bid and ask quotes. Level II quotes

Also known as full market depth. A service of the stock market that displays current bid and ask quotes and the bids and asks from all market makers in a particular stock. Leverage

The ability to control large dollar or other currency amounts of a security with a comparatively small amount of capital. With stock futures this might be on a ratio of 1:25 for instance. Limit

The maximum permitted price move up or down for any given day, under exchange rules. Liquid market

A market which permits relatively easy entry and exit of large orders because there are so many buyers and sellers. Usually a characteristic of a popular market. Liquidity

The capacity within a market to transact volume without affecting price or transaction cost. Measures of liquidity include the total open interest of a contract and the number of contracts available at the bid and offer prices. Long

A position, opened but not yet closed, with a buy order. Long-term debt to total equity

A measure of financial strength. The long-term debt of the company divided by the total shareholder equity for the same period. All other things being equal, a relatively high figure may indicate an unhealthy company. Margin call

A demand for cash to maintain margin requirements. Mark to market

Daily calculation of paper gains and losses using closing market prices. Also used to calculate any necessary margin that may be payable. Market capitalisation

This is the product of the number of shares outstanding and the current price. Market order

See At the market.

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Glossary

Minimum price fluctuation

The minimum price fluctuation possible for a futures contract, the tick size. Momentum

An indicator used by traders to buy or sell. It is based on the theory that the faster and further prices move in a particular direction, the more likely they are to slow and turn. Moving average

A system used by traders to determine when to buy and sell. An average (simple, exponential, or other) is taken of the closing (or opening, or other) prices over a specific number of previous days. A plot is made based on the average. As each day progresses, the moving average has to be recalculated to take account of the latest data and remove the oldest data. Net profit margin

A measure of profitability. Income after taxes divided by the total revenue for the same period. All other things being equal, downward pressure on the net profit margin could provide advance warning of impending share price decline. Offer

A price at which a seller is willing to sell. Open interest

The number of outstanding contracts that remain open. For example, if a position was taken in a contract, and at the expiry of that contract, instead of closing out the position, the trader decided to roll the contract over (open a similar position in the next expiry month), the open interest in that contract would continue. If, however, the trader decided to close out the position, the open interest for that contract would decrease. Open position

A position that has not yet been closed and therefore the trader is exposed to market movements. Overbought/oversold

A term used to mean, broadly, that a stock is likely not to advance further and may decline (overbought) or advance (oversold). Pairs trading

Also known as spread trading. Where you buy one stock and sell another related stock. For instance, if you bought the Coca-Cola stock future and sold the Pepsi stock future. The trader does not care in which direction the market will go, but believes the difference in price between the two will widen relative to each other, allowing a profit. Performance bond

A deposit made by a futures trader protecting the clearing house from the risk of default. Also knows as initial margin.

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Physical delivery

The receipt of the contract’s underlying commodity to fulfill the delivery requirements of the futures contract. An SSF contract’s underlying commodity is normally 100 shares (plus or minus the impact of corporate events) of the common stock. Position

Trades which result in exposure to market movements. Position limits

Imposed during the last five trading days of an expiring product. Price, 52-week high

This is the highest price the stock traded in the last 52 weeks. It may not necessarily be a closing high, it could be an intra-day high. Price, 52-week low

This is the lowest price the stock traded in the past 52 weeks. Could be an intra-day low price. Price to book ratio

The current price divided by the latest quarterly book value per share. All other things being equal, a relatively low figure may indicate the stock is undervalued. Price to cash flow ratio

The current price divided by the cash flow per share for the trailing twelve months. All other things being equal, a relatively low figure may indicate the stock is undervalued. Price to earnings ratio

The current share price divided by earnings per share before extraordinary items, usually taken over the previous twelve months. All other things being equal, a relatively low figure may indicate the stock is undervalued. Pyramiding

The increase in size of an existing position by opening further positions, usually in decreasing increments. Quick ratio

A measure of financial strength. Cash plus short-term investments plus accounts receivable divided by current liabilities for the same period. All other things being equal, a relatively high figure may indicate a healthy company. See also acid test ratio. Return on assets

A measure of management effectiveness. Income after taxes divided by the total assets. All other things being equal, a relatively high or growing figure may indicate a company doing well. 168

Glossary

Return on equity

A measure of management effectiveness. Income available to shareholders divided by the total common equity. All other things being equal, a relatively high or growing figure may indicate a company doing well. Return on investments

A measure of management effectiveness. Income after taxes divided by the average total assets long-term debt. All other things being equal, a relatively high or growing figure may indicate a company doing well. Revenue percent change year on year

A measure of growth. The revenue of the most recent period less the revenue of the previous period divided by the revenue of the previous period. All other things being equal, a growing figure indicates a growing company and should be reflected in a rising share price. Rollover

The transfer of a futures position from one delivery/expiry month to another – involving the purchase (sale) of the nearby month and the simultaneous and corresponding sale (purchase) of a further delivery or expiry month. Round turn

Procedure by which a long or short position is offset by an opposite transaction or accepting or making delivery. Sales per employee

A measure of company efficiency. The total sales divided by the total number of full-time employees. All other things being equal, the greater this figure the more efficient the company. Sales percent change

A measure of corporate growth. The value of sales for the current period less the value of sales for the preceding period divided by the value of sales for the preceding period, expressed as a percentage. All other things being equal, a growing figure indicates a growing company and should be reflected in a rising share price. Scalper

A trader also seeks to enter and exit the market very quickly and thereby make a lot of small profits. Seat

Exchange membership that permits floor trading. Settlement day

The day on which final cash settlement and physical delivery is to be made between buyer and seller. 169

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Settlement price

The price used for daily revaluation of open positions. Shares outstanding

The number of shares issued less those held in treasury. Short

An open position created by a sell order, in the expectation of a price decline and so the opportunity to profit by purchasing the instrument (so ‘closing out’) at a lower price. Short-term debt

The value of debt due in the next twelve months. Spread

The simultaneous purchase of one contract and the sale of a similar, but not identical, contract. Depending on the exact combination, a profit can be made from either a rising or falling market. Stop order (stop-loss orders)

An order left with a broker instructing him to close out an existing position if the market price reaches a certain level. Can be used to take profits or stop losses. Technical analysis

Method used to forecast future prices using the price data alone (for example, by plotting them on a chart and noting direction) or using the price as an input in mathematical formulae and plotting the results. See also Fundamental analysis. Technical rally or decline

A price movement resulting from factors unrelated to fundamentals or supply and demand. Tick

The smallest possible price move. Total debt to equity ratio

A measure of financial strength. The total debt divided by total shareholder equity for the same period. All other things being equal, a relatively low figure is a sign of a healthy company. Total operating expenses

A measure of the cost of running the company. All other things being equal, a lower figure is preferable to a higher one. Transaction costs

The expenses involved in buying or selling a security. These include brokerage commissions, regulatory fees, taxes and the spread between the bid and offer prices. 170

Glossary

Trendline

A line on a price chart indicating market price direction. The line connects at least three price points which touch the line, with no prices breaking the line. Unit of trading

The quantity of the underlying share each single futures position represents. Trades take place in multiples of the unit of trading Volatility

A statistical indication of probable future price movement size (but not direction) within a period of time. For example, 66% probability of a 15 pence move in three months. Whipsaw

A price move first in one direction, and, shortly thereafter, in another direction thereby catching traders wrong-footed. Such markets may be termed choppy. Such effects often give rise to false buy and sell signals, leading to losses.

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172

Euronext, LIFFE and Euronext.liffe Euronext is the world’s first cross-border exchange business, created in September 2000 by the merger of the stock and derivatives markets in Amsterdam, Brussels and Paris. Euronext offers a range of services including the listing of financial instruments, trading in securities and derivatives, clearing, data dissemination and IT support. In 2002, BVLP, the Portuguese exchange and LIFFE, the international derivatives exchange, joined Euronext. Euronext.liffe is the derivatives business of Euronext, comprising the Amsterdam, Brussels, LIFFE, Lisbon and Paris derivatives markets. It is the world’s largest derivatives exchange, by value of the business transacted through the exchange every day. Euronext.liffe is creating a single market for derivatives, by bringing all its derivatives products together on a single electronic trading platform, LIFFE CONNECT®. Euronext.liffe offers one of the most extensive ranges of derivative products, providing futures and options contracts across eight different currencies and six product lines: Short-term interest rates, bonds, swaps, equities, commodities and currencies. Euronext.liffe is the world’s second largest derivatives exchange by volume and by value. A total of 695 million contracts, with an underlying value of over €250 thousand billion, were traded in 2003. Increasing investment in shares in recent years has led to an increase in the use of equity futures and options. In 2003 Euronext.liffe traded 412 million equity product contracts, 251 million in individual equity products and 161 million in equity index products. The equity derivatives market is opening up to private investors with an increasing number of specialised brokers and online trading opportunities. The LIFFE market offers a range of equity products including futures and options on indices, individual equity options, and the revolutionary Universal Stock Futures. Very simply, they are futures contracts on the shares of a range of international companies, which are all traded, cleared and settled through a single trading platform, and regulated under a single regime, without any need to buy or sell the underlying shares themselves. Universal Stock Futures are available on an international list of stocks in seven major currencies: Euros, Danish Krone, Norwegian Krone, Sterling*, Swedish Krona, Swiss Franc and US Dollar. In 2003 Universal Stock Futures enjoyed record trading volumes with Dutch, German, French, UK, Swiss and Swedish based contracts experiencing a substantial surge of activity. For more information, please contact Euronext.liffe Equity Products using the contact methods overleaf. * Universal Stock Futures on UK Stocks are traded via the MATCH Facility

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Alpesh B. Patel on Stock Futures

How to contact Euronext.liffe Telephone

+44 (0)20 7379 2200 Email

[email protected] Websites

www.liffeinvestor.com www.universal-stockfutures.com www.liffe.com www.euronext.com

174

Index Arbitrage 18

Italy - USFs 136

Beta 87

LIFFE. See Euronext.liffe

Bid-ask spreads 16

Liquidity 16

Bollinger bands. See Technical analysis

MACD. See Technical analysis

Brokers 126

Margining 23-25

Chicago Board of Trade 7, 129

Markowitz, Harry 78-79

Chicago Board Options Exchange 7, 129

MEFF 143

Chicago Mercantile Exchange 7, 129

Money and risk management

Commissions 16, 35-36

news analysis 88-89

Company USFs traded 133-137

NQLX

Corporate actions 26 Denmark - USFs 134 Diversification. See Strategies Dividends 25 Euronext.liffe about . . . 173-174 contract specifications 147-151 launch of USFs xi list of USFs 133

Exchanges top 15 exchanges 132 worldwide list 125

Expiry of contracts 20-21 Finland 134 France - USFs 134-135 German - USFs 129, 135-136

contract specifications 155-157 formation of 7 SSFs traded on 141-144

OneChicago contract specifications 153-154 formation of 7 SSFs traded on 138-141

P-USF contracts 20 Pricing 17-18 Regulators 127 Risk and Money Management 99117 Settlement 20 Shad-Johnson Accord 7 Single Stock Futures comparison to USFs 8 launch of 7

Hedging. See Strategies

Software 27

India - SSFs 144-145

Spain - SSFs 143

Indicators. See Technical analysis

SPAN margining system 24-25

Industry Associations 128

Stochastics. See Technical analysis

Initial margin. See Margining

Stop losses. See Trading USFs 175

Alpesh B. Patel on Stock Futures

Strategies diversification 77-80 hedging 81 pairs trading 83-87, 97-98 trading direction 61-75

Technical analysis bar charts 41 Bollinger bands 71-72 divergences 65-66 entry points 37-39 Japanese candlesticks 41-42 MACD 48-54, 63 stochastic indicator 64-65

The Options Clearing Corporation 129 Trading USFs brokers 126 buy-and-hold, contrast to 29-30 data requirements 26 indicators. See Technical analysis pairs trading. See Strategies price targets 66 profitability analysis 45-46 psychology 35 software requirements 27 stop losses 66-68 strategy, developing a 56-59 strategy, types of. See Strategies technical analysis. See Technical analysis time-frames 31, 50-56

Universal Stock futures attractions of 6 commissions 16, 35 comparison to options 11 comparison to spread bets & CFDs 9-10 comparison to SSFs 8 definition 5 dividends 25 expiry of contracts 20-21 history of 7 liquidity 16, 21-22 margining 23-25 pricing 17-18 settlement 20 spreads 16

Variation margin. See Margining 176