Trading College Toolbox
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Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day. Traders that participate in day trading are called active traders or day traders.
Some of the more commonly day-traded financial instruments are stocks, stock options, currencies, and a host of futures contracts such as equity index futures, interest rate futures, and commodity futures.
Day trading used to be an activity exclusive to financial firms and professional investors and speculators. Indeed, many day traders are bank or investment firm employees working as specialists in equity investment and fund management. However, with the advent of electronic trading and margin trading, day trading has become available to the self-employed and those working from home. Some people opt to day trade alongside their other careers, or commitments.
In finance, equity trading is the buying and selling of company stock shares. Shares in large publicly-traded companies are bought and sold through one of the major stock exchanges, such as the New York Stock Exchange, London Stock Exchange or Tokyo Stock Exchange, which serve as managed auctions for stock trades. Stock shares in smaller public companies are bought and sold in over-the-counter (OTC) markets.
Equity trading can be performed by the owner of the shares, or by an agent authorized to buy and sell on behalf of the share’s owner.
Proprietary trading is buying and selling for the trader’s own profit or loss. In this case, the principal is the owner of the shares. Agency trading is buying and selling by an agent, usually a stock broker, on behalf of a client. Agents are paid a commission for performing the trade.
Major stock exchanges have market makers who help limit price variation (volatility) by buying and selling a particular company’s shares on their own behalf and also on behalf of other clients.
The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centres around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.
The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Sterling, even though the business’s income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies.
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous fixed exchange rate regime.
A futures exchange or derivatives exchange is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.
This type of trading was established primarily for the trading of grains and other agricultural products. In brief, futures trading means setting up a financial contract in which you predict the future value of the commodity that must be delivered at a certain time in the future. Trades use a commodities exchange. Commodities can include oil, cotton, minerals, soya beans and pork bellies etc.
Futures contracts must have a buyer and a sell – and either side can speculate. This means that when you BUY a futures contract you are agreeing to buy a commodity that is not yet available for sale at a set price, at a set time in the future.
Alternatively, when you SELL a futures contract you are agreeing to provide a commodity that you do not yet have ready for sale, at a set price, at a set time in the future.
What are Options?
Options are derivatives of the cash or futures markets, known as the underlying markets. Option contracts have prices which are typically a small fraction of the price of the underlying, these markets are analysed first and then trading rules are applied to the options markets.
An option contract gives the holder the right, but not the obligation, to complete the transaction stated in the contract before the expiration date of the contract. There are two basic types of options – call options and put options. The call option gives the owner the right to buy an asset at a particular price, known as the exercise or strike price, before the option’s expiration date. The owner of a put option has a right to sell the stated asset at the strike price before the options expiration date. The price of an option is generally based on the level of the underlying market relative to the strike price, the underlying volatility of the market and the time the option has left to expiry.
Stock XYZ is trading at $20.00 – You think the stock is going to rise over the next few days / weeks/ months – You purchase a Call Option in which you have the option to purchase 100 shares of this stock at $20.00 (strike price) per share anytime in the next 3 months (expiration). The cost of this would be the Option Price and Premium, much less than having to purchase outright the stock to speculate.
XYZ rises to $25.00, your option, the right to buy at $20.00, a much lower price than the current market value will enable you to buy XYZ at a cheaper rate or sell the option for a healthy return. However, if the price of XYZ decreases to $19.00, when your option expires your right to buy XYZ at $20.00 would be of no value, there is no purpose in buying XYZ at a higher price than the current market value. In this case you lose the premium you paid for the option. If you had a longer term option you could retain it giving XYZ the chance to move back in your favour before it expires.
When players are very bullish (or bearish) they will purchase “Out of the Money” Call (or Put) Options, striking price well above the current stock price.
In addition to buying calls and puts you can also sell, or open short positions on them. This is known as writing options (Selling a Call – writer is short the market. Selling a Put- writer is long the market). In this case you receive a fixed premium but your risk is unlimited. Buyers of options have fixed risk, the premium they pay to go long an option returns are unlimited. Therefore the Put / Call Ratio is a good way to gauge investor sentiment and can act as a very good Contrarian Indicator.
Options through spreadbetting
With spreadbetting options you are not physically selling or buying an option and it can never be exercised. You are trading on the value of the option. A spread bet option usually takes the form of a spread market on an underlying exchange based option contract. Buying straight calls or puts is usually more practical than using combination strategies such as ‘writing covered calls’ or ‘straddles’ also known as Exotic Options.
Spread betting in equity and index options is not subject to capital gains tax on profits, whereas option trading in the traditional way can be. It is possible to trade in much smaller sizes in options when using spread betting, the size of a spread bet being determined by the size of your stake (as opposed to the size of the option contract) E.G. a FTSE index option may have a value close to £50,000 (10 times the index value expressed in pounds). An index option priced at 500 involves capital at risk of £5000 in the conventional option. A spread bet on an option priced at 500 at £1 a point involves capital at risk of just £500.
The difference between spread betting on options and normal spread bets on equities or indices is that the margin required to be deposited to open a position is always equivalent to the full value of the option price which means that options traded through spreadbets are no more risky than those traded the traditional way.
For example, January 2013 and the S&P 500 is at 1,520.00 the S&P 500 April Call 1,500.00 bet price is at 132 / 136. You expect the S&P 500 to rally over the coming weeks and therefore buy a position, going long, or £10.00 per point at 136.
Over the next few weeks the S&P 500 rallies, the latest S&P 500 cash level is now 1,650.00 and the S&P 500 April Call 1,500.00 bet price is at 275 / 279. You could cash in your gains by selling £10 per point at 275 (the sell price). You bought at 136 and sold at 275, a 139-point movement in your favour which, at your stake size of £10 per point, nets you a profit of £1,390 (275 – 136 x £10).
If however, the S&P 500 had fallen, you would net a £10 loss for every point the option price moved lower up to a maximum of the price you paid x your stake; £1,360 (0 – 136 x £10).
Spread bet options are always cash settled – when you trade with a spread betting firm no options actually change hands – you are simply betting on price changes. You therefore cannot exercise an option with a spread betting company. You can choose to close your deal at any point against the current price the spread broker is making for that option, or simply leave the option to expiry at which point your position will be settled against the value of the option as defined by the price of the underlying at the expiry point.
Spread betting companies typically quote options on the major market indices, individual stocks and commodities such as gold and silver. Stock market index options are the fastest growing sector in this field and most spread betters buy calls or puts depending on whether they believe the market to go up or down. You don’t have to trade the VIX to acquire exposure to market sentiment, you can also trade options. This is because when volatility is high, options prices tend to rise and vice-versa.