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The Basics

Trading vs. Investing

There is a question which is sometimes asked by those new to the financial markets, and even occasionally debated by experienced participants. That question is how one differentiates between trading and investing. Because both trading and investing – when one considers them from the perspective of the financial markets – are performed in very similar fashions, they are often thought of as interchangeable actions.

A question of scope
In my book, The Essentials of Trading, I followed along with this basic theme by introducing the idea that what differentiates the two is scope definition. Both trading and investing, after all, are at the most simple of levels application of capital in the pursuit of profits. If I buy XYZ stock I expect to either see the price appreciate or earn dividends – perhaps both. What separates trading from investing, however, is that generally in trading one has an exit expectation. This might be in the form of a price target or in terms of how long the position will be held. Either way, the trade is seen to have a finite life. Investing, on the other hand, is more open-ended. An investor will buy a company’s stock with no predefined notion of when he or she will sell, if ever.

We can use examples to help demonstrate the difference. Warren Buffet is an investor. He buys companies which he sees as somehow undervalued and holds on to his positions for as long as he continues to like their prospects. He does not think in terms of a price at which he will exit the stock. George Soros is (or at least was while he was still actively running his hedge fund) a trader. His most famous trade was shorting the British Pound when he thought the currency was overvalued and ready to be withdrawn from the European Exchange Rate Mechanism. The position he took was based on a specific circumstance. Once the Pound was allowed to float freely, and quickly devalued in the market, Soros exited with a handsome profit. That meets the criteria of having a predefined exit, making it a trade, not an investment.

Application of capital
There is another way one can define trading as set against investing, though. It has to do with the manner in which the applied capital is expected to produce a return. In trading the appreciation of capital is the objective. You buy XZY stock at 10 expecting it to go to 15 and thereby produce a capital gain. If dividends or interest are paid out along the way, that is fine, but likely only a minor contribution to the expected profits.

In contrast, investing looks more toward income over time. That makes income production, such as dividends and bond interest payments, the major focal point. Do investors experience capital appreciation? Sure, but unlike in trading, that is not the prime motivation.

With these definitions in mind, consider what many people refer to as their single biggest investment – their home. Based our second definition of investing, however, a home is generally not an investment because in most cases is does not produce any income. In fact, it produces considerable expenses in the form of mortgage interest payments, utility bills, and upkeep. If anything, a home is a trade. We buy it and hope for its value to rise over time, increasing our equity. And the fact that many people expect to move in only a few years and sell at that point makes it even more of a trade rather than an investment. (Of course owning rental property can certainly be viewed as investing, unless one is flipping it, which would definitely be more trading.)

Different or the same?
As noted earlier, for many people trading and investing seem like the same thing. The mechanics of buying and selling are basically the same. Sometimes the analysis done to make those decisions is identical as well. It’s the intention and definition of objectives which separate trading and investing, though.

Categories
Trading Tips

Trading vs. Gambling

Last weekend I was in Las Vegas – strictly a business trip. Although I’ve been to that city seven or eight times, I’ve not once lost a penny gambling. Why? Because I’ve never even played the slots while there. Gambling is just not my thing. I guess it’s hard to get beyond the fact that it’s a losing proposition in the long-run. Yes, there is the entertainment value, but I’m just not that interested.

Trading is often compared to gambling. On the one side there is the element of chance – the idea of the unpredictable outcome. While it can certainly be said that for any given trade any outcome is possible, that’s as far as it can go. In gambling the odds are stacked in the house’s favor so the more you play the more likely you are to come out on the losing end. This is not the same for trading because in the markets you can develop a plan and a strategy which puts the odds in your favor. Does that mean making money every trade? Of course not. But a well conceived trading plan can ensure that you will be profitable in the long-run.

The other side of the trading-gambling comparison is the entertainment perspective. Gambling is intended to be entertainment, despite all the efforts to make a killing at the tables or whatever. Trading, though, is not supposed to be for entertainment value. It’s all about profits. Anyone who plays the market for fun has to seriously evaluate what he/she is doing because enjoyment and long-term profitability often do not go hand-in-hand.

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Deep Posts Trading Tips

It’s OK to be on the sidelines

Keep in mind that you don’t have to trade. Many traders get in trouble because they feel like they always have to be active. This simply is not true. In fact, it can be detrimental to your overall performance.

One of my favorite quotes is from Jim Rogers, author of Adventure Capitalist, Investment Biker (very good read) and Hot Commodities. In his interview in Market Wizards he made the statement that he just waits until he sees a pile of money sitting in the corner and picks it up. This is a great lesson from an extremely successful trader/investor. Rogers doesn’t just make a trade or take on a position because he feels like he has to. He does it when his analysis tells him its the right thing to do. In other words, he lets his trade selection methodology tell him when to be active in the markets, which means sometimes he’s going to be out. That’s not a bad thing, though.

Categories
Trading Tips

First of all, know thyself

One of the most important elements of success in trading (and life in general) is knowing yourself. If you do not understand how you tick, you will never be truly prepared for the demands of trading, and likely your performance will suffer as a result.

Let me use myself as an example.

I am what might be considered project oriented. By that I mean I like to move from one thing to the next – always have something upon which to focus my attention. As my friends and colleagues can attest, once I complete a project – and sometimes even before I do – my thoughts shift to the next one. I actually get antsy if I have nothing lined-up. Predictably, this is reflected in my trading.

We can actually think of trading as a series of projects. Each position one takes on is a new project which incorporates analysis of some sort (automated or otherwise) and trade decision-making. When a position is closed out, it is like wrapping up a project. It’s over and done – time to move on to the next thing.

There’s a little problem with that, though. This kind of “project” approach, in the case of someone like me, can lead to overtrading. This isn’t the kind of overtrading which is referred to when one speaks of taking on positions which are too large, though. Rather, I am speaking of trading too frequently. In my case, when I close a trade I find myself immediately eager to open a new one. It doesn’t matter whether I made or lost money on that first trade. Because of my “need” to have a project going, my psychological pull is toward finding a new trade to make. (Note: I do not consider this in my case to be like the “fix” trading provides as an intermittent feedback mechanism, like gambling.)

This little personality trait of mine is something I figured out a while back when I realized that I am most comfortable when I have an active position in the market.. It doesn’t matter how large or small that trade is as long as I can check on it periodically and feel like I’m involved. Knowing this, I take two approaches to avoid the overtrading problem.

The first thing I do is trade longer-term. By doing so, I give myself the opportunity to take on long “projects”. I often have trades with durations of weeks or even months. These aren’t all my trades, mind you. I do trade short-term at times, but my schedule is such that longer-term position trading tends to fit best most of the year.

When trading shorter-term, I use a second approach to combat the “project” itch. Specifically, I try to step away from the market for a while following the completion of a trade. It lets me clear out the emotional residue of finishing a project and come back at it fresh. That can quite often make the difference between taking impulsive trades and being properly selective based on my analytic methods.

Of course, this is just one example of the sort of psychological hurdles which come up in trading. We all have patterns of behavior which are based in our personal lives that can quite easily carry in to trading, positively or negatively. Brett Steenbarger’s outstanding book The Psychology of Trading provides an excellent discussion of how this can happen, and ways we can overcome the problematic ones. The primary point is that we need to be able to look at ourselves like an outside observer. In that way we can get to know ourselves, and that’s at least half the battle.

Categories
Best Of The Basics

An Introduction to the Fixed Income Market

This article is a basic introduction to the fixed income market.  It covers the primary facets and features of fixed income as they relate to trading from the individual, as opposed to institutional, perspective.

The term “fixed income” is used to describe a collection of securities which have predefined pay-out terms.  An example would be a certificate of deposit (CD) in which one deposits a set amount of money and in return receives a given amount of money, which includes both the original deposit plus interest income, at some future date, known as the maturity.  Fixed income securities, unlike stocks, are based on loans.  While one might think of “buying” a CD, what he/she is in fact doing is loaning the bank money, for which they are paying interest.  That interest, which is predetermined in some fashion at the outset, is the “fixed income”.

Money Markets
Fixed income securities come in a wide array of maturities.  Those with initial maturities of one year or less trade in what is often referred to as the money market.  This term comes from the fact that these short-term instruments tend to be very liquid and often traded between banks.  Money market instruments included such things as:

  • Bankers’ Acceptance: A draft or bill of exchange accepted by a bank to guarantee payment of a bill.
  • Certificate of Deposit: A time deposit with a specific maturity date shown on a certificate; large-denomination certificates of deposits can be sold before maturity.
  • Commercial Paper: An unsecured promissory note with a fixed maturity of one to 270 days; usually it is sold at a discount from face value.
  • Eurocurrency Deposit: Currency deposits in a domestic bank branch or a foreign bank located outside the country of the currency in question.  For example, Eurodollars are deposits of US Dollars outside the United States.
  • Federal Agency Short-Term Securities (in the US): Short-term securities issued by federally sponsored agencies such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
  • Federal Funds (in the US): Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve.  These are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
  • Municipal Notes: Short-term notes issued by municipalities (cities, towns, counties, etc.) in anticipation of tax receipts or other revenues.
  • Repurchase Agreements: Short-term loans – normally for less than two weeks and frequently for one day – arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
  • Treasury Bills: Short-term debt obligations of a national Treasury issued to mature in 3 to 12 months.

Most of the securities above are out of the realm of the individual trader, but a handful can be traded, generally via the futures markets.  Money market instruments normally trade at a discount which means the buyer (lender) pays some amount below the final pay-off value.  For example, if a Treasury Bill is going to pay 100 at maturity, the buyer might pay 95.  The difference would be the interest earned.

Notes and Bonds
The intermediate term fixed income market is made up of securities which are generally (but not exclusively) referred to as notes.  They are instruments which have initial maturities of two to ten years.  Bonds, on the other hand, are the longer-term instruments with initial maturities of more than ten years at the time of issuance.

The standard structure of notes and bonds are the same.  They each feature a par or principle value which is paid at maturity, as well as intermediate interest payments, referred to as coupon payments, which are paid out on a predefined periodic basis (monthly, semi-annually, etc.).  The coupons represent the nominal interest on the bond or note.  For example, if a bond has a 100 par value, and a coupon of 10 per year, that means a 10% interest rate.

Notes and bonds, however, will not always trade at par value. Depending on the overall interest rate market, they can be priced at a discount (below par) or at a premium (above par). The result is that the effective interest rate may not be the same as the nominal rate. For example, if the bond  above were trading at 90, the effective interest rate would be 11.11%. Note, though, that the bond price of 90 represents a 10 point discount off the 100 par value. Those 10 points become extra profit to the bondholder when he/she is paid par at maturity. That then becomes part of the yield to maturity equation. If the bond in the example has a 20-year maturity, its yield to maturity is about 11.28%. Were the bond trading at a premium (above 100), then the yield to maturity would be lower than both the effective and nominal interest rate.

Notes and bonds are both actively traded on a number of exchanges. Individual traders can transact in them via either the cash or futures market.

Callable vs. Non-Callable
Some fixed income instruments are callable. That means the issuer can essentially buy them back from the holders prior to maturity. Normally there are specific terms related to this such as a date after which calling is allowed, or not allowed. When an issue is called, the holder receives the par or principal value, and sometimes a premium as well, depending on the call conditions.

Issuers
Fixed income securities are issued by a wide array of organizations. Probably the best known and most liquid of them all are the government instruments, which are often referred to as sovereign debt because they come from national governments. They come in a wide array of varieties and maturities from country to country, though the most commonly traded securities tend to be the notes and bonds. They have names like Gilts (UK), Bunds (Germany), and JGBs (Japan). Individuals can trade in government debt via the cash market through direct purchase, or they can go through the futures market.

Corporate debt is also quite well common. A great many companies issue debt as an alternative to issuing more stock. Many of these issues, generally notes and bonds, are listed and traded on stock exchanges. As such, they are readily tradable by anyone with a brokerage account.

States, counties, cities and towns also issue debt, which is commonly referred to as municipal or muni debt. These issues are often less well known and actively traded than government or corporate securities. Unlike the other two, however, they often come with incentives for the debt holder such as the interest being federally tax-deductible.  As such, they will generally trade at lower yields.

Government agencies and quasi-government agencies also issues fixed income instruments. Among the best known in the U.S. are the Federal National Mortgage Association (FNMA – Fannie Mae) and the General National Mortgage Association (GNMA – Ginnie Mae). Like government debt, these instruments are accessible to the individual through either the cash or futures market.

The last major group of issuers is the supra-national organizations such as the World Bank.  These issues are not commonly a part of the portfolio of the individual trader, but can be transacted in the cash market.

Credit Ratings
Fixed Income securities all have ratings assigned to them by one or more credit agencies. These ratings are an indication of the creditworthiness of the issuer. They are essentially an indication of how likely the instrument is to be paid off by the terms of its issuance. The higher the rating the better. For example, the sovereign debt of most major industrial countries is of the highest rating. So too are those of many large corporations. An issuer need not have a top level rating for it’s securities to be considered a good risk, though the yields will generally increase with lower debt ratings.

Non-investment grade debt, or junk as it is often called, is the collection of securities which carry low ratings. Issuers with ratings in this category often have high amounts of debt outstanding, may possibly have defaulted, or otherwise are considered to be in financial stress, suggesting that the debt holder is at risk of not being paid off as per the terms.

Influences on Fixed Income Prices
Since the fixed income market is driven by interest rates (prices are inversely related to yields), those things which impact on rates directly influence prices. The biggest driver of these rates, from a macro perspective, is monetary policy, the decisions central banks make in regards to the level of domestic interest rates. Since the central banks directly control interest rates (at least short-term rates), they have a heavy influence over their level and direction.  Other, less direct, influencers include:

  • Government fiscal policy
  • General economic growth
  • Employment
  • Inflation
  • Currency exchange rates and trade

Obviously, when considering the likes of corporate debt, considerations related to that particular issuer come in to play. This includes things like earnings, total debt outstanding, interest cover ratios, and others. All of this, though, is also account for in the credit rating.

Yield Curve
The yield curve is the graphic portrayal of yields over the array of maturities, from shortest to longest. An example is shown on the following chart.

sample yield curve

Notice that the plot above depicts two lines. The blue line is the more standard, upwardly sloping yield curve in which the longer-maturities feature higher yields. The spread between the long maturity issues over the short maturity ones is positive. The pink line, shows an inverted, or negatively sloped curve. A negatively sloped curve is often considered an indication of a pending downturn in the economy as the higher return on short term money will tend to prevent longer-term investment.

It should be noted that while it is most often the case that when one discusses yield curves that it is the government rate curve to which is being referred, it need not always be the case. There are yield curves for corporate debt, for example.

Additional Topics

  • Mortgage-Backed Security (MBS): Instruments which are based on commercial and residential property mortgage loans. These loans are packaged together and securitized by the likes of Fannie Mae. The primary consideration for an MBS is that since mortgages can be prepaid, the actual maturity of the security is unknown, though it can be estimated.
  • Convertible: Some bonds and notes (mostly corporate) can be exchange for another security (generally stock). For example, a company could issue a bond which allows the holder to convert the bond in to 10 shares of company stock. The terms of these conversions are pre-set in terms of price of the security into which the issue can be converted, and oftentimes also the time frame in which the conversion is allowed. The price of convertible securities are heavily influenced by the price of the security they are convertible into.
  • Inflation Protected Securities: This is a group of fixed income securities which are tied in to inflation, as measured by the Consumer Price Index (CPI) or some other similar measure. The interest and/or principal payments of such instruments vary based on a formula. The idea is the nullify the influence of inflation on the holder so that the real rate of return (nominal rate minus inflation) will remain fairly steady.

Further Study

This article is but a brief introduction to fixed income. If you wish to go further, consider the following as worthy resources.

[easyazon-link asin=”0071768467″]The Handbook of Fixed Income Securities[/easyazon-link]

[easyazon-link asin=”B004OC01CM”]Interest Rate Markets - A Practical Approach to Fixed Income[/easyazon-link]

[easyazon-link asin=”0750660783″]Bond and Money Markets - Strategy Trading Analysis[/easyazon-link]

[easyazon-link asin=”0470850639″]Fixed Income Strategy  A Practitioners Guide to Riding the Curve[/easyazon-link]

[easyazon-link asin=”1556232896″]The Bond Market - Trading and Risk Management [/easyazon-link]

 

Categories
Trading Tips

How the Financial Markets Can Grow More than Just Your Bank Account

The financial markets provide us with the opportunity to grow in ways that most people probably do not even think about. We all know of the gains in wealth to be had buying and selling stock, bonds, commodities, currencies, and other instruments. One need not look far to find stories about the riches to be had. Successful traders, investors and portfolio managers like George Soros, Peter Lynch, and Warren Buffet have become household names. What is less commonly talked about is the personal development which takes place along the way.

Trading and investing, like any worthwhile pursuits, provide more rewards than just the obvious accomplishments. To paraphrase the old saying, the destination is not always as important as the path taken to get there and the things seen along the way. While it is true that the expansion of one’s portfolio is what ultimately indicates success or failure in the markets, how those gains are achieved can provide outstanding opportunities to learn important lessons about ourselves with far reaching value. These lessons reach across all areas of our lives.

Playing to Your Strengths
We all have our strengths and weaknesses and a kind of structure in which we operate based on the demands on our time, education, experience and an array of other factors. In the markets we need to make assessments about these things to help us decide what to trade, the timeframe in which to operate, and how to make our trading and investing decisions. Why? Because it is unlikely that we will achieve our objectives if we do not honestly judge ourselves and how best we can operate. For example, I am unlikely to be a good day trader if I cannot dedicate my days to watching the markets for long stretches and frequently buying and selling. I must either choose another course or alter my schedule to accommodate the demands of being a day trader.

It is the same in the rest of life. We must constantly consider our personal inventory and life situation. They dictate what we can do and how we can do it. That said, these are not static things. Just as I noted above that I could alter my schedule to allow for day trading, so too can we change things to expand our options. Education, in all its forms, is part of that equation. So too is seeking out new experiences, meeting new people, and even consciously changing our attitude toward things. If a goal is important enough, there are things we can do to make achieving it possible. Part of that is knowing what we have to work with and how to most efficiently apply it. The other part is knowing how to open up new avenues.

Knowing Who to Listen To
In the markets there is a vast array of information available. It comes in every form imaginable, from data released by the government to commentary by analysts to tips from Uncle Joe. Some of this information is useful to us. Some is not. A great deal of what came out in the aftermath of the stock markets collapsing in 2000 and after was the number of conflicts of interest those who provided “expert” opinions had. These people did not have the interests of those they spoke to about this stock or that at heart, but rather their own and/or their firm’s. Many, many people listened to these pundits to their detriment. Clearly, a hugely important element of successful trading is knowing what information is of value and which sources can be trusted, and what should be taken with a grain of salt.

The same holds true in all other areas of our life. All of us are constantly provided with information and advice. Some is solicited. Much is not. Before we can decide whether to make use of it all we must be able to assess the veracity of the source. Some people are trustworthy and wise. We can depend on what they say. Others do not have our best interests in mind. We must carefully consider what they say and the motivations behind it, before deciding whether it is worthwhile or should be ignored all together. Being able to effectively judge the input we receive from sources such as our family, friends, and peers is a priceless skill.

Being Disciplined
Success in the markets is achieved by doing what we know is the right thing to do. The single biggest reason people fail to consistently produce the returns they seek is that they fail to maintain a disciplined approach. Sound familiar? It is the same as anything else we do. Want to lose weight? You must be disciplined about diet and exercise. Want to learn how to play guitar? You must exercise the discipline required to practice the hours required to attain the skill.

Understanding Why You Fail, Knowing How to Succeed
Perhaps the single greatest thing about trading and investing in a meaningful fashion is that it provides a fantastic opportunity to see what you do which causes you to fail and what leads to success. The conscientious trader/investor has a plan and thereby a way to make evaluations. Whether things go to plan and profits accrue, or they do not go well, he or she knows why and what needs to be done going forward.

Achievement in life requires that one follow a similar course. No matter the objective or pursuit, we must understand what it takes to succeed and have ways we can judge whether we are doing those things or not. To do otherwise is to act in a random fashion, never sure if we are doing what is right and necessary.

These are just some of the valuable life lessons that trading and investing can provide. There are plenty more as worthwhile, to go along with the more commonly thought of value in understanding how the markets can be used to improve your financial well-being. And these lessons need not come at great expense either since modern trading and investing can be done with very small amounts of money – even none at all in the case of demo accounts. All the more reason to make the markets a source of both financial and personal growth.

Categories
The Basics

Economic Data and its Influence on the Financial Markets

The things which contribute to price levels and action in the financial markets are numerous and diverse, and their influences can vary through time, and across different markets. This article identifies the different types of Economic Data influences and the role they play.

There are two ways economic information can influence prices. The first is in the macro sense. Macroeconomic inputs include:

  • Interest Rates
  • Economic Growth (GDP)
  • Government Budget Surpluses/Deficits
  • Trade Balances
  • Commodity Prices
  • Relative Currency Exchanges Rates
  • Inflation
  • Corporate Earnings (both for individual companies and the broad collection)

These elements will generally all have long-term inputs in to the pricing of any given market. They do not tend to move in sharp, dramatic fashion, so their influences also tend to be seen over longer periods of time.

That said, the release of economic data related to the above can be seen to have serious impact in the short-term activity in the markets. This comes primarily in the form of data releases. Some of the most important are:

  • Employment Data
  • Trade Data
  • GDP growth figures
  • Consumer & Producer Inflation rates
  • Retail and Wholesale Sales
  • Confidence & Sentiment Readings (U. Michigan survey, etc.)
  • Income & Spending
  • Production
  • Interest Rate policy decisions
  • Earnings releases

The markets can react in very, very dramatic fashion to these releases when they are out of line with expectations. The foreign exchange market, namely the EUR/USD exchange rate, provides a striking example.

On one Friday morning at 8:30 Eastern the monthly Non-Farm Payrolls report hit the wires. This report (released on the first Friday of each month) probably provides the most short-term volatility across all market sectors of any regular economic release. When the data comes in well off of market expectations, fireworks can ensue, as was the case in the example. Over the course of about 2-3 minutes EUR/USD fell more than 20 pips, turned around and rose about 60 pips, then fell back down to near where it had been before the data was announced (a pip being 1/10,000 of a Dollar). It then proceeded to run nearly 100 pips higher in fairly steady fashion over the course of the next hour.

Here is another example, this time of T-Bond futures.

When those payroll figures were released at 8:30 the market dropped more than two full points. One point on the T-Bond futures contract is worth $1000, so each contract fell more than $2000 in about two minutes. Consider that the margin on a contract at the time was probably around $2500. That means a trader could have lost more than 80% on the trade in the blink of an eye.

It is also important to understand that in the futures pits such data events often result in fast market conditions. This means that the action is so hectic that there may literally be trading going on at several different prices in different parts of the pit. This is a risk of having open positions at the time of a major news release. The market may snap back fairly quickly, as in the chart above, but in the meantime the trader’s positions may have been liquidated on a stop order at a substantial loss.

Fortunately, all major economic releases are well documented. They are done on a pre-announced calendar which is readily available on any number of web sites, and of course in the business news media. In the vast majority of cases, one can also find out ahead of time from any number of sources what the expectations are for the release.

Foreknowledge of pending data events may not prevent losses which may result from unexpected figures. It will, however, allow the trader to recognize and understand when risks are increased. Make sure, especially if you are a short-term trader, to know what data is coming out. It can make a difference in your performance.