The Role of the Regulators
Government regulators act as watchdogs, overseeing trading in the securities or futures industries. Although industry officials sometimes complain about too much oversight and regulators sometimes claim the industry isn't providing enough, the check-and-balance tension between them helps to guard the public interest and maintain a level trading field for all investors and traders. Nearly everyone can agree that a balance of regulation is a good thing because its existence gives the public comfort and confidence that an outside source is guarding their interests.
In addition to providing or approving market regulations, the regulators also provide traders and consumers with valuable details about the status of brokers and firms, warnings about investment scams, advice on how to invest and other useful information. Their enforcement actions or threats of action reduce the negative aspects of the industry and help to keep it as "clean" as possible.
Regulators on the equities side include the Securities and Exchange Commission (SEC), www.sec.gov; Federal Reserve, which controls margin requirements, and the National Association of Securities Dealers (NASD), www.nasd.com. Regulators for the futures industry include the Commodity Futures Trading Commission (CFTC), www.cftc.gov, and the National Futures Association (NFA), www.nfa.futures.org. Generally, persons who handle your money must be registered with a regulatory agency.
The Securities Industry Association (SIA) and the Futures Industry Association (FIA), www.fiafii.org, are the national trade organization for these types of trading instruments.
How to Pick a Broker
The broker you select depends on the level of service you need. An experienced trader may get along well with a discount brokerage firm that merely executes orders at low commission rates whereas a beginning trader needing more help may be willing to pay higher commissions for the services of a full-service brokerage. There is no single, best answer to which broker is the best because there are many different types of traders and brokers.
Like any profession, there are differing degrees of quality in futures brokers and brokerage firms. Obviously, your first goal in selecting a brokerage firm should be finding a firm that is reputable. Your personal broker within that firm is like your employee because he/she will be working for you and you will be paying him/her. So you may want to interview them just as if you were hiring someone for a position.
A broker should be honest and have your best interests in mind - not a "churn and burn" pitch man who racks up big commission fees by cajoling you into trading all kinds of markets. Sometimes traders find it hard to blame themselves for unsuccessful trades, and the broker is an easy scapegoat. Certainly, there are a few "bad eggs" in the brokerage community, just as there are in every industry. However, the vast majority of futures brokers are honest and hard-working individuals who do have your best interests in mind when it comes to trading.
No matter whom you select as a broker, you have to take ultimate responsibility for your own trading decisions. At the same time, it is not an exaggeration to say that the ultimate success or failure of some traders lies in the hands of their brokers.
Decide what you want from a broker before you begin your search. If you trade electronically and only need fast order executions at low cost and an accurate accounting of your trades, a discount brokerage may be the best for you. If you need price quotes, background research and other types of information to make a decision and need to have help in framing orders, you should look for a full-service brokerage firm, even though you will have to pay more in commissions. If the broker helps you get into profitable positions, they are well worth the fees they charge.
If you have the money but lack the time or knowledge to trade your own account, one aspect of your search may be to find out whether the brokerage firm has money managers or trading systems that can trade an account for you. You may even want to have one account traded by a professional and another account that you trade yourself as one way to diversify your trading portfolio or to see how your trading skills compare with an expert's.
Less-experienced traders will probably want to avoid the overly aggressive broker, who can make trading an intimidating experience, especially since many newer traders are often still learning the terminology and may be confused by sometimes-hard-to-understand trading concepts. Find a broker who can talk to you on your terms comfortably.
As an individual trader, you and not your broker should always be in control of your trading account and your trading decisions, even if you are inexperienced. If your broker gives you recommendations, you can certainly act upon them. But it's your money, and you should control your trading decisions. Helpful is one thing, pushy is another. Find a broker who is compatible with your style of thinking and trading - one who will answer your questions and work hard to get good fills for you if you are not trading electronically but who will not question why you want to make a particular trade or give you his opinion on a trade.
Having made the case for making your own decisions and controlling your own trading, keep in mind that many brokers do their own research and provide their information to customers, including trading opportunities. This type of research may be as high in quality as any available, so don't rule out using information from brokers or advisors in making your trading decisions or relying on their expertise. They are usually in a better position to analyze markets than you are.
Check out any brokerage firm or individual broker by contacting the National Futures Association (www.nfa.futures.org) and using its "BASIC" system, which performs searches of brokerage firms or individual brokers to find out if they have had any infractions levied against them by the NFA. The Commodity Futures Trading Commission (www.cftc.gov) also has an informative website that can help size up a new broker or brokerage firm.
How to Place Orders
No matter how much analysis you do or how sophisticated your software is, virtually nothing in trading is more critical than entering your orders properly. It is hard enough to determine the trades you want to take. Communicating your trading decision to the market can be another challenge if you are a trading newcomer - unless you work with a broker or experienced trader who can explain the terminology, the strategies and the nuances of the various orders.
Remember, it's your money the broker is holding so you should be very careful about telling the market what you want to do with your money.
Before discussing the various types of orders, here are a couple of important points:
Not all orders are accepted at all exchanges or by all brokerage firm trading platforms. Check with your broker to be sure which orders you can use for the markets you trade.
Entering a trade is not the end of the order process. Be sure that you get a confirmation that your order has been executed and the price at which the order was filled. That fill shows where you stand in the market and may be the key to followup orders such as stops.
Never assume that a broker or a computer knows what your position is or what you are trying to accomplish. If you say or click "sell" instead of "buy," your order is likely to get executed, and you may wind up doubling the size of a short position when you thought you were closing out the short position.
Keep your own order log, especially open orders because they may lie in some forgotten queue long after the market has moved away from the area where they were placed and give you a big surprise if they are filled.
Types of Orders
Below are some of the most common types of orders and where you might use them, either to enter or exit a position. To understand the consequences of an order more fully, you may want to work with a broker, at least initially, until placing orders becomes second nature to you.
A market order is the most common type of order and should be used whenever you want your order to be executed immediately. You do not have to indicate a specific price because the order will be executed as soon as possible at whatever the next available market price is. Once this order is placed, it cannot be canceled because it is filled immediately.
Keep in mind that the next available price may be far removed from the price at the time you placed your order in wild market conditions. This is known as "slippage" and can be one of the most costly aspects of trading, especially in "thin" markets that may have large price jumps. Do not use "at the market" orders in thin markets or in volatile conditions unless it is imperative that you get into or out of a position at whatever price you can get. Although those situations do exist sometimes, the market may take advantage of you if you resort to the market order.
Market on Close (MOC), Market on Open (MOO)
Some traders call this order "murder on close" or "murder on open" because those typically are the periods of the regular floor trading session when the markets are most active and the odds are higher for the execution price to be away from the posted current price. These are just market orders that must be filled within the price range during the official designated closing or opening time periods. The MOC order may be very useful to close out a day-trading position that you do not want to hold overnight, but keep in mind that it does have its risks.
A limit order specifies a price limit at which the order must be executed - you get the price you want or better or you don't get a position. A limit order lets you know the worst price at which your order will be executed. However, you cannot be certain that a limit order will be filled because the market may not trade at your price, or there may be only a few trades at the limit price level you specified and yours is not one of the orders filled. With a limit order, the tradeoff for being sure about the worst price you can get is that you may not get a position at all.
A buy limit order is placed at a price lower than the current market price. A sell limit order is placed at a price higher than the current market price. Some traders add "or better" to a limit order to reinforce their intent, but that is implied in a limit order and is not necessary.
Market If Touched (MIT)
A market-if-touched order combines some features of both the market order and the limit order. Like the limit order, a MIT order may be executed only if the market reaches a particular price. Unlike a limit order, when that price is reached, the MIT order becomes a market order, executed at the next possible price available. That means a MIT order could be executed at the MIT price, at a lower price or at a higher price.
An MIT buy order becomes a market order if and when the market trades at or below the order price. The MIT order does not guarantee that you will buy at the limit price or lower. On the other hand, if the market bounces back above the MIT price, it does get you into a long position whereas a limit order would not.
An MIT sell order becomes a market order if and when the market trades at or above the order price. The MIT order does not guarantee that you will sell at the limit price or higher. If the market falls back below the MIT price, it does get you into a short position whereas a limit order would not.
The advantage of the MIT order is that you know your order will be filled if the MIT price is hit. The disadvantage is that you do not know the worst price at which the MIT order might be executed because it is subject to the same market gyrations as the market order once the MIT price has been reached.
A "stop" is another common order because traders are always being admonished to trade with stops to protect their accounts. The stop is often used as a protective order, but it is also a good way to get into a new position. A stop order is essentially a market order but only if and when the market reaches a specific price. The specified price acts as the trigger that converts the stop order to a market order. Until and unless that trigger is pulled, your market order stays on the shelf waiting to be activated.
A buy stop order is placed at a price higher than the current market price. It will become a market order to buy only when the market moves up to that price. Like any market order, the trade may be executed at the stop order price, at a lower price or at a higher price, depending on the next best possible price available.
A sell stop order is placed at a price lower than the current market price. It will become a market order to sell only when the market moves down to that price. Like any market order, the trade may be executed at the stop order price, at a lower price or at a higher price, depending on the next best possible price available.
The chart above will help to illustrate the difference between a limit and a stop order, the most common orders after the market order. You could have taken a long position one of two ways:
A buy stop order at the blue line would have become a market order once your stop price was hit. Note that there was some slippage as the market gapped above your stop order, but it did get you into position for the uptrend.
A buy limit order at the red line would have gotten you into a long position at that price or lower. If you did not expect prices to dip too far below the earlier lows indicated by the red line support, a buy limit order placed at that level was a good choice. If prices had barely touched the red line, however, the danger is that your limit order might not have been filled at all, and you might have missed the start of the uptrend.
On the other hand, a sell limit order at the blue line would have gotten you into a short position at that price or higher - in this case, much to your chagrin if that is the type of order you chose. A sell stop order at the red line would have become a market order when that price was hit, and you would have been short at the next possible price, which might have been at, above or below the red line stop price - again, not a good thing in this case as the market turned around right after you got into a short position and moved sharply higher. Of course, you probably would have adjusted your orders to offset that position before losses mounted too high.
Stop Close Only
Like a market on close order, this variation of a stop order limits the time of execution to the closing trading range. If the stop is hit prior to that that time, the order is not executed. If the market is trading higher than the buy stop price or lower than the sell stop price during the closing range, the order becomes a market order and is filled at the best possible price.
Stop Limit Order
If the stop order sometimes serves as a protective order, then the stop limit order acts as sort of a protective order for the stop. Because stop orders become market orders when the specified stop price is hit, the order can be filled at almost any price. When a surprise news event hits the market, for example, prices can make a huge jump. Or when the market approaches a critical chart point that suggests a breakout, numerous stop orders may be sitting above or below that point and may create temporary erratic price movements if the stop is hit.
You may be one of those with a sitting order waiting for the breakout, too, but you are not willing to pay any price to get onboard. A stop limit order acts like a stop order in every way except for one provision: You will not accept a price that is worse than the limit stated. Like any limit order, the risk is that you never get onboard a runaway market that never looks back.
Cancel, Cancel Former Order, Cancel/Replace
All of these orders cancel previous orders, provided, of course, that you enter them before the original order has been executed. Several notes about cancel orders:
You cannot cancel a market order; it should already have been executed.
Many electronic markets do not allow "good 'til cancel" orders. You have to enter a new order such as a stop every day.
In some markets any "open" or "good 'til cancel" order remains active until it is filled, you cancel it, or the contract expires; it does not go away because you may have forgotten about it or because you may have thought you were offsetting it with a different order later.
If there is any question as to whether an order has been canceled, contact your broker immediately; if a cancel order is too late, you may wind up with two positions instead of one or you may be holding a position you never expected.
One Cancels Other (OCO)
A one-order-cancels-the-other-order is a two-sided order that is sometimes used to bracket a price range when you are unsure about the price direction and want to go with the breakout either way. You could place two separate orders in this situation, but the problem is that both might be filled in a swinging market. You could be locked into a quick loss or wind up with a larger position than you wanted or just become totally confused.
For example, you may have decided that you want to be short a market so you enter an OCO order - one limit order above the current price to sell in case prices go up and one stop order below the current price to sell in case prices slide through some point. You only want one position, but you want to be prepared for either eventuality. Your OCO order tells the broker to fill one order, not both of them, to get you short whichever way prices move.
The Role of the Exchange
Other than the trading that takes place in the more specialized over-the-counter markets and cash foreign exchange trading, the exchange is the centerpiece of much of the trading action in derivative instruments, whether trading is conducted via open outcry on a trading floor or electronically on a computer.
In recent years exchanges have been challenged to keep up with advances in technology, with changes in ownership from member-only entities to publicly traded companies and with the development and expansion of competitive new exchanges operating in a global environment. Technology requires huge investments in equipment and software applications as more and more participants trade electronically, but it also reduces the per-trade cost of trading, allows more new products to be offered online (sometimes the same product offered on another exchange) and improves the speed and efficiency of trading, which attracts even more trading.
Here are some roles that exchanges fill in the trading process:
Whether trading occurs in a pit or a computer, the exchange provides one centralized location where buyers and sellers can gather to match their orders. This pool of traders expedites the price-discovery and risk-transfer processes. Details about the results of this trading activity provide the price structure for many of today's markets.
Every viable business has to offer products or services. In the trading world it is the exchanges that create, develop and market the products that are traded, frequently doing the research to support the contract and producing the materials to promote their markets to traders. Exchanges do not own the product or carry an inventory; they just turn concepts into a tradable contracts and post them for the world to see and trade.
Exchanges have developed a set of detailed trading rules over the years that govern how trading is conducted in a central location. These rules protect traders, whether on a trading floor or a computer screen, dictate how various orders should be handled and place restrictions on price manipulation, front-running or insider trading. Maintaining the integrity of the trading process is vital to building trust and confidence in the marketplace, which is what allows exchanges to function in the first place.
Futures exchanges also set performance bond requirements for all of its contracts, a role that the Federal Reserve has for the equities markets.
For every buyer, there must be a seller, and for every seller there must be a buyer. The exchange provides the facilities and the rules to match buyer and seller and makes trading a more orderly process than the chaotic scene sometimes depicted in the media.
A clearing organization, sometimes operated by the exchange and sometimes a separate entity, works with clearing members of the exchange to make sure that all positions balance out, assuring that the appropriate amounts of margin money are deposited and resolving any discrepancies. In futures, the clearing organization actually acts as the buyer to every seller and the seller to every buyer to protect against the risk that a counter-party will not hold up its side of a transaction.
The Role of the Brokerage Firm
Although most trading takes place on an exchange, you can't get there without going through a broker, your entrto the trading world. In fact, your only contact with trading may well be your broker as you may not know or care which exchange is executing your order.
The broker serves a number of functions in addition to holding your trading account and transmitting your orders to the exchange. Depending on the level of service you require, the broker can educate you about trading; provide you with data, price quotes, research reports and other information; offer trading recommendations, or perhaps even trade your account for you in a managed account. For more information on how to determine what type of broker you need, see the section in this tutorial on picking a broker.
At a minimum a brokerage firm serves as a conduit to expedite your orders, reports confirmations and provides you with account statements of your activity.
An important broker function is to determine traders' "suitability" for trading various instruments based on their financial status and their eligibility to trade specific positions based on the amount of money in their account. As a gatekeeper to the trading arena, the broker also helps the futures or securities industry maintain the integrity of the trading process by screening every customer and every order as part of its fiduciary responsibility to collect, hold and monitor the funds you entrust to a segregated customer account.
All U.S. brokerage firms must be registered with government regulatory agencies. Depending on their level of financial backing and the services they provide to traders, futures brokerage firms may be classified as futures commission merchants (FCMs) or introducing brokers (IBs). Individual futures brokers are registered as associated persons (APs).
Many people associate futures with risk, but after the technology stock bubble of the late 1990s and the accounting scandals and fraudulent dealings at Enron, Worldcom and other companies, futures may look a lot less risky than many stocks. Futures do have some inherent risk, but they can also actually reduce some of the risks that exist in the investment world. For the active trader, futures offer one of the best ways to get big returns quickly while helping you keep your risk under control.
Here are the characteristics of a futures contract:
Temporary Replacement for a Future Transaction
A futures contract is an agreement today to meet the terms and obligations of a contract that matures at a specific date in the future. When you buy futures, you do not "own" anything but have the right to benefit from price appreciation; if you hold a long physical commodity futures contract until expiration, you may take delivery and own the actual commodity. If you sell futures, you do not "owe" anything but have the right to benefit from price depreciation; if you hold a short physical commodity futures contract until expiration, you are required to deliver the commodity to the buyer under terms specified by the contract.
One of the first things you need to realize about "margin money" is that it does not mean the same thing in the futures market as it does in the equities market. The futures contract does not involve a down payment for future delivery as is the case in stocks. Instead, futures involves putting up an established "good-faith deposit" or a "performance bond" that confirms your willingness to fulfill the terms of the contract. It's like earnest money in an escrow account and is required for both the buyer and seller of a futures contract.
Exchanges set the minimum performance bonds for each futures contract, and these amounts change as market conditions change. Typically, the amount is only 3%-10% of the value of the contract, but the amount could be greater in volatile market conditions.
In many transactions, specifications can be tailored to fit the needs of both parties, and the contact may be one of a kind. In futures, one contract is the same as any other futures contract for the same market, same month and same size. Contracts are interchangeable or fungible. The only thing in a futures contract that is not standardized and regulated is the price at which the transaction takes place. The corn you would receive at delivery for one futures contract, for example, is the same grade and type and quality as for any other corn futures contract.
Futures contracts have two key characteristics: (1) They must be traded at a centralized marketplace - an open-outcry or electronic exchange - where all bids and offers come together and are matched in trading conducted by specific rules under the oversight of government regulators, and (2) the terms of the contract are guaranteed by a centralized clearinghouse so you never have to be concerned about a default on a contract. The exchange's clearing agency takes the opposite site of every futures transaction and resolves any potential disputes.
Futures have an expiration date, usually a relatively short time into the future for the most active contract months. There is no buy-and-hold in futures because when the contract expires, it is settled according to the terms specified and goes off the board. Therefore, in addition to price direction, futures traders also have to consider the time frame within which they expect a price move to occur.
Why Futures Exist?
Futures are important tools in the business world for several legitimate purposes:
Futures trading provides the means to determine market value in a centralized marketplace that brings together all the "bid" and "ask" (or "offer") prices to arrive at a value agreed upon by both the buyer and seller. Like any other auction market, traders bid on an item for sale and discover what other people think it is worth in a competitive setting. Bids and offers come from a variety of sources with a variety of motives for being involved in the market. By centralizing all buying and selling activity with the largest possible pool of participants, the market determines value at that particular moment in time.
For many physical commodities still traded on an open-outcry floor, the price established at the exchange is the price quoted around the world and is the basis of much physical trading.
Other than price discovery, perhaps the most useful purpose of futures is to transfer risk from someone who has it to someone who is willing to assume it. The market underlying futures carries real risk. Those bearing the risk of price change - producers of a commodity or owners of stocks in a stock index, for example - may use futures to pass that risk to someone who thinks the market will provide them with a profit for their willingness to take the risk.
All markets carry a risk for someone, whether prices go up or down. Futures produce no new risk but just shift the risk that exists in a transaction where both parties hope to benefit from a price movement in their direction.
Why Trade Futures?
"Commercials" or "hedgers" usually have business reasons for using futures to lock in prices or profit margins. For them, futures provide a way to reduce risk and to develop a sound business plan because they can remove some of the uncertainty about the future.
For many other futures market participants, however, the most important feature of futures is the ability to speculate on price movement with a relatively small amount of money. Here are some reasons why traders like futures:
One of the first terms associated with futures is leverage - a small amount of money in futures has the potential to produce big returns. Of course, that feature can also have a downside if you do not manage your risk carefully. That means you need to monitor a futures position more carefully than you do most other trading instruments.
Here is a simple example to illustrate the power of leverage:
1. Assume you have $10,000 to invest/trade. You buy 500 shares of a $20 stock, paying the full price or all $10,000. If the stock goes up $5 a share or 25%, you gain $2,500 (500 shares X $5). Your return on investment is 25% ($2,500/$10,000).
2. You use the $10,000 to buy 1,000 shares of a $20 stock, paying the required 50% minimum margin and borrowing the rest. The value of shares you own is now $20,000. If the stock goes up $5 a share or 25%, you gain $5,000 (1,000 shares X $5). Your return on investment is 50% ($5,000/$10,000).
3. You put the $10,000 into a futures account and use it to buy two e-mini S&P 500 Index futures contracts. With the index at 1200, the value of your futures position is $120,000 (2 X 1200 X $50 per point). If the price of the index goes up 25% or 300 points, you gain $30,000 (300 points X 2 contracts = 600 total points X $50 per point). Your return on account is 300% ($30,000/$10,000). Of course, an index spread over 500 stocks is not as likely to rise 25% as is one $20 stock, but even if the S&P 500 Index goes up only 5%, you make more than you would with the 25% rise in stock prices.
What is important to remember is the other side of this leverage if the market should fall 25%. In Example 1 with the fully-funded stock purchase, a 25% loss would be $2,500, leaving you with $7,500 of your original starting amount. In Example 2 with the partially-funded purchase, a 25% loss would be $5,000, leaving $5,000 remaining in your account. In Example 3 with two e-mini futures contracts, a 25% loss or 300 points would amount to $30,000 or three times your starting account size. And you would be legally obligated to pay if you rode through that decline. Even if the e-mini dropped only 5% to 1140, you would lose $6,000 or 60% of your account.
While leverage can work for you, it can also work against you, making risk management and cutting your losses short two of the most important steps in futures trading.
Ease of Selling Short
One concept that seems to be difficult for many traders to grasp is the ability to sell something they don't own. In futures, however, remember that you don't own anything but are only agreeing to abide by the terms of the contract at some later date. Your performance bond acts as your guarantee for that agreement. Your futures position is simply the right to speculate on price movement up or down between the time you enter the position and the time you offset it.
Therefore, it as easy to sell futures as it is to buy. Everything about the trading process is the same except that you say "Sell" instead of "Buy." In addition to "buy low, sell high," you can also "sell high, buy lower."
Fast, Efficient Transactions
Futures transactions can be executed in seconds on a trading floor or in nanoseconds electronically. With today's technology and many participants normally willing to take the other side of any order, you usually get not only a speedy turnaround but also into and out of a position at prices close to what you want. Bid and ask spreads are relatively narrow in the most active markets, which can absorb sizable orders without disrupting the flow of prices.
In addition, the costs of establishing a futures position are quite reasonable as commissions have gotten lower and lower as competition has intensified recently.
Without futures to provide protection, some participants could face losses from adverse price moves. Even if you have a relatively small investment portfolio in stocks, you might consider using single stock or stock index futures to provide protection against a downturn in the stock market while keeping stock holdings intact. Or if you suddenly receive a large sum of money that you want to invest in stocks, you could put the money to work quickly with a position in futures while you assemble the portfolio of stocks you want.
The Business of Trading
Many investors talk about getting into trading as a business, but before you can do that, you really need to have an idea what the business of trading is all about - the instruments you can trade, the role that various participants in the industry play, how to pick the right instruments and the right firms for you, how to conduct your trading, etc.
In general, when you put your money into something that gives you ownership and may be held for an indefinite period of time, you are considered to be an "investor." Buying real estate or stocks are prime examples. When you use your money to speculate on price movement of an instrument derived from a physical or financial product, you usually are dealing with a time factor and are considered a "trader" because you are likely to trade in or out of positions over a shorter period of time.
This tutorial will focus on the trading aspects and give you the background you need to move on to the market analysis process.
What Is a Good Trading Instrument?
As a trader, you can choose the product you'll trade from among a number of financial instruments today. Your choice depends on your knowledge of the various vehicles and your trading style.
This tutorial deals only with those instruments traded on a regulated exchange or with foreign exchange contracts traded at cash forex firms. You could also be a trader in the over-the-counter market or some other swap or auction arrangement, but those venues are beyond the scope of consideration for most beginning individual investors.
In addition to being exchange-traded, here are some characteristics good financial instruments should have in common:
Ties to the cash market. Financial instruments are typically replacements for transactions in the actual cash market, so you want an instrument that has a solid connection to the "real" market and has a basis for existence.
Price movement. Prices of the instrument have to be move enough to provide profitable opportunities for traders, yet not be so volatile that they are gyrating uncontrollably up and down without much reason. An instrument whose price does not change or moves only minimally is not an attractive place to tie up your money. When the price of an instrument does move, you want the movement to be relatively fluid without a lot of gaps that may make it difficult to get into or out of positions.
Liquid. Tied to the item above, volume needs to be sufficient to allow you to get into and out of positions with a minimum amount of loss due to slippage. A market with many smaller positions is usually better for in-out trading that a market dominated by a few large block orders. You want to be able to get in smoothly but, more important, out just as smoothly whenever you want.
Transparent. Complete information about prices should be available to all traders, regardless of account size. You want an open marketplace where everyone has access to important statistics and data and current prices at the same time. Some traders prefer electronic markets for this reason because trading is not conducted in an inner circle on a trading floor out of the view of off-floor traders.
Contracts sized for your account. You can't trade contracts that are too large because you may not have enough money in your account, and you don't want to trade contracts that are too small because the increased commissions could wipe out your profits. Trading a $100 stock or a full-sized S&P 500 Index futures contract that requires a minimum deposit of nearly $20,000 may be beyond your means, for example, and would involve too much risk. The instrument has to offer a contract size that matches the size of an account.
Other than some type of savings account or other interest-bearing instrument, the first venture into investing for most people is probably the stock market, either in individual company equities or in mutual funds of many different types. Many people have a stake in the stock market through their 401(k) or other retirement plans.
Buying a stock gives you a piece of the company, entitling you to collect dividends and gaining from any appreciation in the value of the stock. Companies sell these shares to raise money for all kinds of reasons, granting ownership rights rather than borrowing money and paying interest. Unlike many derivative instruments, stocks do not expire and can be held indefinitely. For that reason,
The supply of a company's shares is fixed. With a limited number of stocks, competitive buying and selling determines the price of the stock. Stock markets normally operate with a specialist system with market-makers responsible for making markets in specific stocks.
The Federal Reserve sets the margin amounts for stocks, requiring investors to have a minimum of 50 percent of the price of stock in their account as a down payment to own the stock. It is much more difficult to sell stocks than buy them as selling usually has to be done on an uptick, and you have to borrow shares from a brokerage firm's inventory if you want to sell. If you borrow margin money to buy shares or borrow shares to sell, you pay the broker interest.
Trading Individual Stock Instruments
You have a number of alternatives to become involved in the stock market as either an investor or trader.
Individual Company Shares
You have thousands of choices, and your biggest challenge is to pick the right stock from the right sector from the right overall market environment at the right time. Much of the analysis for investing in individual stocks involves scanning through the vast array of stocks to find those that meet the criteria you select. Getting accurate data and reliable information about a company in a timely manner can make it difficult to get an edge.
Instead of buying shares in the company, you can use options to buy or sell the right to be long or short the company's shares at a specific price.
Single Stock Futures
Futures on major individual stocks began trading in November 2002 but still trade on a relatively small scale. Single stock futures do provide greater flexibility and tax advantages for those wanting to buy or sell selected major stocks.
Trading 'Market' Instruments
Many investors do not have time nor expertise to evaluate and select the "right" individual stocks so various instruments have been developed to capture the performance of a broader spectrum of stocks.
Mutual funds package stocks from a sector, from a region, the market as a whole or many other ways to provide a diversified fund based on a collection of individual stocks. Basing performance on a number of stocks reduces risk and can enhance profits compared to investing in a few individual stocks. Funds can be geared to provide aggressive growth, growth and income, long-term appreciation or a number of other investment goals, and their performance is often measured against some benchmark.
Mutual funds have become so popular and the number of funds so numerous that it is now as difficult to pick a "good" mutual fund as it is a stock. Although these funds offer diversity and professional management for investors, they have some limitations and may not be the best vehicles for active traders.
Rather than select individual stocks for a fund, some funds just include all of the stocks in an index such as the S&P 500 Index or one of the sector indexes. Their performance should roughly coincide with the performance of the index.
These derivatives are also based on an actual cash index such as the S&P 500 Index (SPX) and the S&P 100 Index (OEX), which cover a number of stocks. Overall market direction and time are important elements to consider.
Exchange-Traded Funds (ETFs), Index Shares, Index Tracking Stocks
These products act like an index but are traded like a stock and have become very popular since they were introduced by the American Stock Exchange in 1993. More than 300 ETFs are available today. The most popular leaders include:
- DIA or "DIAMONDS" - based on the Dow Jones Industrial Average and priced at approximately 1/100 of the value of the DJIA.
- QQQ or "Qubes" - based on the Nasdaq-100 Index and the most successful index share contract. It is priced at approximately 1/20 of the value of the index.
- SPDRs - based on the S&P 500 Index.
- Select Sector SPDR Funds - based on nine specific industry sectors.
- WEBS - World Equity Benchmark shares on 17 different foreign countries based on Morgan Stanley Capital International (MSCI) Indexes.
- HOLDRS - depository receipts on selections of stocks in various areas.
ETF instruments offer traders a number of advantages:
- Invest in a portfolio of stocks represented by an index with a single transaction in one stock-like instrument.