Reader Questions Answered

Looking at Risk and Stops Across Markets

Here’s the core of a note I received from a member of my mailing list a short while back. It speaks to a subject some traders struggle with.

Have been studying trading for several years, traded a bit with various levels of success. Looked hard at Forex, but am now rather taking a liking to E-Minis: reason is risk. I find it relatively easy to limit your risk by catching a move with a tight hard s/l & moving s/l in the E-Mini, but for forex all strategies I normally see require a s/l of 20 – 35 pips. I do not like that at all.

What is your view?

It appears as though this individual is caught up in a faulty perspective. He’s focused on points (or pips) rather than what they represent.

In an S&P 500 e-mini contract a single point is worth $50, with the minimum price change of 0.25 being equal to $12.50. By comparisson a 20 pip move in the forex market could represent any number of possible values. Taking EUR/USD as an example, if we are trading a micro contract (1000 EUR) it would be $2.00. For a mini contract (10,000 EUR) it would move up to $20. When we get up to a full lot (100k EUR) it reaches $200.

In other words, depending on the size of your position, a 20-35 pip forex trade risk could be substantially smaller than the smallest possible movement in the e-mini contract. If the trader above is risking 2 points on his e-mini trades (for example), which is $100, then he could trade 5 mini EUR/USD contracts risking 20 pips  and have exactly the same exposure.

You shouldn’t compare markets on point/pip a basis. Focus instead on a value basis, especially a % of portfolio one.

Trading Tips

Selecting stocks and ETFs suitable for trading

Picking the best markets and vehicles to trade is a major part of developing your overall trading plan. A question which came in over the weekend speaks to that subject.

I am new to trading and was interested in understanding how to select stocks or ETFs that are suitable for trading.  I have heard some people say that the leveraged ETFs and inverse ETFs might not make good trading vehicles but it would be helpful to understand the criteria that should be used to develop a short list for monitoring.  I’m specifically interested in vehicles suitable for trading trends several days to several weeks in duration.

The best advice I can offer on this subject is to compare the performance of a collection of stocks and/or ETFs with different volatility characteristics in terms of your trading system or methodology. Some trading approaches are better suited to more volatility and others to less. Also, if one is trend trading, there is the question of drawdowns and how comfortable you will be sitting through the inevitable ones. Higher volatility stocks and ETFs will tend to produce larger draw downs than lower volatility ones.

As for how to identify the stocks and ETFs with different levels of volatility, I suggest using the Normalized Average True Range (N-ATR) indicator. This is something I wrote about in the May 2006 edition of Stocks & Commodities. I also talked about it in the latter part of this ATR article on Trade2Win. Basically, N-ATR is ATR divide by either the current close or an n-period moving average matching the look-back period of the ATR calculation. This lets you see ATR expressed as a percentage of stock price, making it directly comparable between different markets and instruments.

The upshot of all this is that you can use N-ATR to pick out the stocks and ETFs with higher or lower relative volatility. Generally speaking, the most price-active ones will have daily N-ATR above 2% – often times well above.

Of course you could come up with other criteria for selecting your stocks and/or ETFs. Volume could be part of the mix. For a swing-trading timeframe trend oriented approach, identifying stocks and/or ETFs that are trending in the longer-term timeframe could be part of the equation as well. There are loads of different screenable characteristics. It really depends on how you want to trade.

No matter how you ended up dividing up your stocks and ETFs, though, the bottom line requirement is testing, testing, and more testing.

Reader Questions Answered Trader Resources

Are there any ETFs for trading gold, oil, and soybeans?

Dave Mabe from Stock Tickr passed along a question he’d seen that he thought I could answer.

Are there any ETFs that trade 99% equal to crudeoil, soybeans and gold future contracts?

I’m not sure whether the inquirer is asking if there’s an ETF which includes all three of those commodities, or whether the question is if there are ETFs which track each of those commodities seperately. I’m going to answer based on the idea of three seperate ETFs because I can’t imagine there’s one which is includes all three together and almost nothing else.

For gold the SPDR Gold Trust (GLD) is basically a gold tracking stock. It’s not based on the futures, but rather the spot rate, which should serve the purpose just fine.. It’s priced based on the value of 1/10th of an ounce of gold.

In terms of crude, the United States Oil Fund, LP (USO) is probably the most popular pure oil futures play. It regularly trades more than 10 million units daily. It’s pricing, unlike the GLD, is not directly comparable to the price of oil.

As for soybeans, I’m not aware of an ETF which focuses specifically on that particular commodity. There are a number of Agricultural ETFs, one of the most popular of which is PowerShares DB Agriculture (DBA). It includes futures on a number of different commodities.

For a full list of ETFs (and there are a lot of them) visit Yahoo’s compilation here.

Reader Questions Answered

How Can Interest Rates Go Below Inflation?

Today’s question focuses on interest rates and the fixed income market.

I do not understand how interest rates could be less than inflation. Historically, 90 day tbills track inflation plus a small premium. Now with inflation at let’s say 4% or so, how can everything shorter than 30 years be BELOW the inflation rate…way way below!

First off, we need to make sure we keep in mind that interest rates are determined by markets just like stocks or forex rates or commodity prices. As such they are subject to the same sorts of supply and demand considerations and emotional behavior as any other market.

In the current market environment, safety is a major consideration. People are willing to pay a premium for it, and that means being willing to accept negative real rates of return. This is what is meant by a flight to quality or a flight to safety. I means folks want to put their money somewhere that has virtually no chance of losing them capital.

For those who think of the fixed income market as being the steady, stable one, take a look at this quote board from yesterday’s trading:

Treasury market interest rates on March 24, 2008

I’ve been in this game for a long time and it hasn’t been too many times that I’ve seen movement like that across the board in the Treasury market.

Reader Questions Answered

What’s Your Opinion of Options Trading?

A reader named Bill asked the following question about options trading by way of leaving a comment the other day:

I love your posts. I read every day.

I am studying options. I am curious about your opinion of options and the advantage they provide to the trader.

Firstly, I love options. Personally, I rarely trade individual stocks anymore. I prefer to trade the options instead. They offer a much greater opportunity to manage risk, and I’m not just talking about at the outset, but also throughout the course of a trade. They also allow you to put less of your capital to work in a position, which could give you the ability to better spread out your trades, if that’s something you wish to do.

Secondly, options need not be complicated. You will hear a lot of people say that they are, and they certainly can be, but they do not have to be. Very simple directional trades can be made through them if you have a solid understanding of the basics. You don’t need to understand all the Greeks and whatnot to trade profitably using options. Yes, there are ways of trading options which require a deep understanding of some pretty intense concepts, but that isn’t a universal thing.

I have done some course type work on simple options trading before. Might be time to dust that off an put the material out there again.

Reader Questions Answered

Commodities Trading: Is it Worth Exploring?

Commodities have been a huge talking point in the market for a while now, and even more so in recent days given the big time volatility. That being the case, it probably comes as no surprise that I received the following question.

Hello John,

What is your opinion or take on Commodity ETF’s. Is it something I should look into, If yes where would be a good place to start?

I’m half way through your course and enjoying it. 

Regards Charles 

If you are looking for a place where you can play volatility and day or otherwise short-term trade an active market, then commodities are definitely worth a look. The big movements and high volume are providing loads of great opportunities.

For someone new to the markets looking to play commodities, the ETFs are probably a better starting point than the futures market, which used to be the only real way to play commodities (you still hear people refer to the futures market as the commodities market sometimes). They aren’t leveraged like futures, so the risks are much reduced. You’re not at risk of losing your whole account in ETFs as is possible in futures (a look at the lock limit trading in Cotton recently demonstrates exactly how that can happen).

Here’s the problem, though. Many of the ETFs out there are grouped, where there are even ones that cover the market you’re interested in. For example, you could have an ETF that covers soft commodities, for example. Yes, there are ETFs specific to gold and oil, but they are fairly unique, at least in terms of readily available and active options.

Of course you could also look at ETFs on companies involved with the commodities of your interest. Gold miners and steel companies are examples of groups with active ETFs. And naturally there are the stocks themselves directly. The risk there, though, is that the companies don’t perform as well as the commodity because they introduce the element of earnings and whatnot.

As you can see, there are loads of alternatives. It all comes down to how you feel most comfortable approaching the market.