The Basics

The Cost of Trading

Last week I wrote a post for the Currensee blog addressing a recent SmartMoney article attacking forex trading from the perspective of costs. The article was full of misinformation of the sort I’m coming to expect from those writing about forex (and trading in general) from a journalistic point of view. I wasn’t shy about taking the author and her editor(s) to task for the piece’s short-comings.

One of the core elements of the discussion in my post was the impact of spreads on one’s trading. In the spot forex market spreads are readily visible because that’s how the market presents price feeds. In exchange-traded markets, however, spreads are often quite opaque because it’s traded prices that are the dominant presented part of prices feeds. The fact of the matter is, however, that bid/ask spreads exist in all markets.

Over the last couple days I’ve been collecting spread indications from a wide array of markets at random 15-30 minute intervals during the NYSE trading day (to ensure that all markets involved are open and active rather than including pre-market and other non-primary sessions). Here is the result of the study including some of the most actively traded market instruments.

The equity instruments were selected based on regular inclusion among the most actively traded securities (on a shares basis), so the list includes a couple of index ETFs as well has high profile individual stocks. The Treasuries list includes the current on-the-run securities, meaning the ones most recently auctioned. The futures prices are for the standard contracts except where specifically noted. Prices for the noted forex exchange rates are from the EBS dealing system. All of the above information was derived from real-time prices. (Keep in mind that markets less active than the ones presented here will tend to have wider spreads.)

The Data
I’ve a couple of primary sets of information in the above table. One is the spread. In order to standardize the comparison, I’ve expressed that in terms of the dollar value of the spread relative to a $100,000 trade. Obviously, these securities trade in a wide array of different contract and position sizes, so this isn’t meant to indicate some real-world fixed contract value. The $100,000 was just selected to make the spread values as expressed in dollar terms easy to understand and compare side-by-side. The “Avg $ Sprd/$100k” column shows what the average spread was based on about 30 intraday observations, with the “$ Sprd Rng” column indicating the range of spreads observed.

On the right side of the table I’ve incorporated broker commission estimates to provide a second set of comparative information by way of total trading cost. I’ve used $7.95 per side for the equity trades and $7.95 per round turn for the futures contracts. Brokers often will do commission-free transactions for Treasury trades, so no commission is factored in there. Similarly, zero-commisson trading is readily available for retail forex trading, so no commission is factored in there either. Obviously, the reader can replace what I’ve listed with their own numbers for a more personal comparison.

And the winner is…
If you want lowest cost trading then you want to stick to the short-term interest rate market. Spreads on 2yr and 5yr Treasury Notes are under $10 for a $100k trade, and they average under $3 for 3mo Eurodollar futures (note that this is Eurodollar, not the EUR/USD exchange rate). It’s worth noting that these are the very same markets where my volatility comparison between markets shows the lowest levels of volatility.

Beyond the short-term rates securities, the all-in cost of trading for the major forex pairs holds a modest edge over most of the other instruments included in the study. The futures markets, however, are mostly fairly close. It’s in the individual stocks where we start to see the total costs extend away from the overall group average, largely because of the broker commissions.

Market maker’s dream
Of course the one figure jumping off the page is the spread cost of Citi (C) stock. The bid/ask spread is $0.01, and the stock is (at this writing) trading below $5. That means the spread value is quite a bit higher than the same spread for the Qs trading in the $50s. Now consider that 350-400mln shares of C traded during the period of the study. That’s better than $1.7bln worth of volume. At about $205/$100,000 we’re talking about something around $3.5mln in spread differential per day!

It’s good to be a market maker in Citi shares these days!

Factoring in leverage
Note that in now way is leveraged trading factored into the figures above. They only reflect costs per $100,000 traded. That means costs as related to the value of one’s account is going to depend on how much leverage is being applied. For example, someone trading $100,000 worth of EUR/USD on a $10,000 account (10:1 leverage) will have a cost of about 0.1% ($11.10/$10,000). Similarly, someone trading $100,000 of the SPY on a $25,000 account (4:1 leverage) would have a cost of about 0.09% ($23.14/$25,000). To fairly judge the cost comparison between markets, one needs to do so on the basis of how much leverage is being applied and how frequently trades are being done.

The Basics

How Markets Can Fall Without Actually Trading

One of the things many market participants fail to realize is that prices do not require transactions taking place to move. In fact, they tend to move most rapidly in the absence of trades. Why? Because when transactions are taking place it means buyers and sellers have come to at least a temporary agreement on value. Prices move most aggressively when there is no agreement, when one side has to give in to the other and alter its perception of value.

The confusion about all this comes from the fact that the most commonly known exchange price feeds show only transacted prices, not the bid/offer indicative prices which actually underlie everything. Forex traders don’t suffer this problem, of course, as they are used to see an indicative market. Most options traders are also well aware of this issue as thinly traded options can show last trades that are vastly different than the current price at which a trade could be done.

So here’s the deal. When all the buyers disappear from the market – meaning they pull their bids – the market falls until it finds a level at which the buyers are willing to come back in. That means market orders can get filled WAY below where they were expected to be filled. That seems to be at least part of what happened during the market plunge last week.

Here are a couple of good examples (hat tip to Wall St. Cheat Sheet)

“Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929 showed that what is mysterious is not inevitable. Often there were no buyers, and only after wide vertical declines could anyone be induced to bid… Repeatedly and in many issues there was a plethora of selling orders and no buyers at all. The stock of White Sewing Machine Company, which had reached a high of 48 in the months preceding, had closed at 11 on the night before. During the day someone had the happy idea of entering a bid for a block of stock at a dollar a share. In the absence of any other bid he got it.”
John Kenneth Galbraith, 1955, The Great Crash

“I started accumulating stocks in December of ’74 and January of ’75. One stock that I wanted to buy was General Cinema, which was selling at a low of 10. On a whim I told my broker to put in an order for 500 GCN at 5. My broker said, ‘Look, Dick, the price is 10, you’re putting in a crazy bid.’ I said ‘Try it.’ Evidently, some frightened investor put in an order to ‘sell GCN at the market’ and my bid was the only bid. I got the stock at 5.”
Richard Russell, 1999, Dow Theory Letters

This leaves one with the very legitimate question as to whether it is a good idea to use market orders or standard stops, which become market orders when their trigger price is met or passed.

Reader Questions Answered

Why teach others how to trade?

A question came in this morning from a “fan” of The Essentials of Trading Facebook page. It speaks to a combination of topics, some of which I’ve seen a few places recently and all of which come up frequently in new trader circles. Here’s the edited question:

My question is simple… if your teaching of trading is successful, why tell other people ? I think a successful trade will not open his secret… and the rule of forex trading is if someone gains others lose. Sorry I just think that people invite others to trading, actually want them to spend their money and lose.

The question has a few parts, so let me address them separately.

Why share?
The first response I would have to this question is that there are millions of traders out there. They operate in all different markets, trade the full spectrum of trading time frames, and use more different strategies than could be imagined, and are not all motivated by profits. New traders  tend to have blinders on, thinking that the whole market operates in the same time frame and market they do, with the same motivation.

Consider this. Some traders are scalpers getting in and out in minutes, if not seconds. Some trader are market makers, not looking to play direction, but rather to buy at the bid and sell at the offer over and over again. Some folks are day traders, while others are swing traders, and even more are position traders. Some folks trade spreads between two or more instruments (long one, short the other). A large portion of the market (especially in forex) is related to hedging, which is something with no profit motive at all, but is about protection.

My point is that I could tell tens of thousands of people the exact same thing and not have it impact my own trading or what happens in the markets at all. Traders, especially on the retail side, are way too paranoid about this sort of thing. If you’re talking about a strategy which is used by big money managers then maybe we have a different story.

Zero sum game
While retail forex trading is generally speaking a zero sum game, when you start talking about actual foreign exchange transactions when currencies are really swapped for things like international trade then it isn’t. At that point it’s more like the stock or physical commodity market (as opposed to futures, which are zero sum) where you can have longs without shorts. See my earlier The Zero Sum Game post.

Why would a successful trader teach?
As for the question of why someone who is making money in the market would bother teaching, I will refer you to the Those Who Can’t Trade Teach and Why I do this trading education thing posts.

Trading Tips

Fighting the Ignorance of Traders Who Claim They Know

It’s ranting time!

There’s a certain blogger out there who’s only purpose for posting (seemingly) is to sell his trading guide, or whatever he calls it. I’m not even sure why I bother to look at his posts. It must be to occassionally get me pissed me off at his hubris and ignorance enough to turn his foolish blathering into an educational post here.

The latest entry (I’m not going to do him the favor of linking to it and helping his page rank) is full of nonsense like this bit here:

There are certain types of trading instruments that I feel should not be peddled. One is the futures market. I’ve never traded the futures but this is a highly leveraged form of trading and it’s just stupid because 99% of all traders who delve into this arena will fail.

There is no market in which 99% fail, so right there he’s killed his credibility with anyone who knows anything – if he hadn’t already done so by saying he’s never traded futures. Yes, the failure rate is high. But it’s also high for his preferred market, which is individual stocks (and it a whole lot of other activities one could get started in).

Read this and remember it well:

Leverage is not the reason people fail in trading. It just punishes more severely those who fail to manage risk.

After relating the story of a trader who ran a small amount up to a large one and right back down, this blogger even makes my point:

It was lack of risk management and money management that made him $4 million very quickly and also the lack of risk management and money management that caused the demise of his account.

That’s the brightest point he made in his whole post bashing all but his favored market.

After he got done with futures he trashed penny stocks and options (for some reason he starts calling people involved in these “mouth breathers”), claiming he particularly hates the latter because buying them is a big scam. Here’s why:

In order to win, you have to get EVERYTHING right – the timing, the magnitude and the direction. The time decay is always eating at your money every single day. Similar to penny stocks, you cannot put too much of your money into one trade or you risk immediate ruin. Putting 1-2% into each options trade means you will need 50-100 great trades (of 100% gain each trade) to double your initial principle. That’s almost an impossible task!

I’m not going to deny that if you want to make directional plays in options that timing is a critical factor. I would contend, though, that magnitude and direction are something which any straight out stock trader has to get right as well. And it’s absolutely true that you cannot put too much money in any one option, just like you can’t put too much in any one stock. We just had the risk management discussion.

As for needing tons of winners to double your portfolio, apparently someone doesn’t really grasp the upside potential for options. It’s nothing for one to double. If you catch the right moves you could be looking at 5- or 10-baggers, and up. Oh, and not everyone is necessarily out to double their money each year.

So what does this braggart trade?

The best way still is trading mid to large cap stocks. They are alot safer than those trading instruments mentioned above. And you can still make huge gains, like I did last year being mostly on the long side in a terrible bear market.

Anyone who’s followed my writings for any time now will no doubt anticipate what I’m about to say.

Safety is not about what you trade. It’s about how you trade.


There is no best market – only the best market for you.

I don’t know this guy’s methodology, and don’t really care. If it works for him, that’s fine. It might work for others as well. I’m going to guess that some options folks would have ideas for ways they could use take that approach and apply it successfully in that market. I know that for the way I trade stocks, options work very well for providing great risk management and expanding opportunities. Again, that may or may not work for others. I do not, however, make any suggestion that my way of doing things is the only or best way. There are a lot of perfectly workable trading methods, and money can be made in any market, though some are clearly better for some traders than for others for any number of reasons.

I hate it when these types of people claim that their market is the only one that makes sense to trade. It makes me want to slap someone upside the head. I don’t care a whit how good their performance is.

Trading Tips

Want Trading Advice? Answer These Questions

If you’re a new trader asking me for advice about how you should move forward I’m almost invariably going to ask you two questions:

1)  Have you figured out what is the best timeframe for you to trade?

2) Have you picked the market that best suits you?

These two questions, to me, are the foundation for everything else. Granted, there’s a prior question everyone must ask themselves before they get started, which is “Should I trade?”, but for the sake of this discussion I’ll assume that’s been asked and reasonably answered.

Why are these the foundational questions?

Because they set up everything else.

Trading Timeframe
Your trading timeframe feeds into the choices you make regarding:

  • Market Traded
  • Instruments Traded (cash/spot, futures, options, etc.)
  • Trading Frequency
  • Market Analysis/Trade Selection Methodology
  • Risk Management Approach

The trading timeframe you choose should be the one you can operate in most consistently. Don’t pick a timeframe based on what you think you should do. This is how many unsuccessful day traders make their decision, for example. They think day trading is the path to the real money and try to shoehorn it into their school/work/life schedule when it just doesn’t fit. Most people are not suited to day trading because they don’t have the regular market hours available to them day in and day out. They would be better off with a longer timeframe focus.

When you know what timeframe you’re going to trade in you then have the basis for deciding on things like those listed above. Some markets may or may not work for your timeframe. For example, stock day trading is hard outside exchange hours, but forex trading goes on 24 hours. Some trading instruments may be better suited than others, like perhaps opting for ETFs to trade commodites rather than futures if you’re trading somewhat longer-term. Trade selection will have to be more technical as your timeframe becomes shorter. That’s just to name a few of the follow-on decisions.

Market to Trade Selection
Really, I could stop here with timeframe, but I think the market question is important too because it encourages you to give real thought to where you’re going with your trading. You want to pick a market that suits your timeframe, appeals to your interests, fits your financial situation, and offers you sufficient quality trading opportunties.

Don’t trade a given market because it’s the thing to do. A lot of people ill suited to forex trading, for example, were sucked into that market during the middle part of this decade because it was the hot market. Most of them got spit out because it wasn’t a best fit for them.

The market you decide to trade then becomes part of these trading choices, among others:

  • Instruments Traded
  • Market Analysis/Trade Selection Methodology
  • Risk Management Approach

Making Thoughtful Decisions = Being Focused
Obviously, there’s some overlap here and market also potentially comes out of the timeframe decision. The point is, though, that by going through this process you narrow things down so you can focus better. A major short-coming of new traders is that they lack focus and bounce around markets and timeframes and trading systems based on the last thing they read or saw which impressed them. If you take the time to think about your timeframe and then the market you trade, it will not only give you a solid foundation, it will help you in the process of making the next layer of decisions, like what specifically to trade and how to go about doing so.

Trading Tips

Fixed Income and Stock Trading

I have written before on the value of understanding the fixed income market. Interest rates play a roll in every other market to a greater or lesser degree. Sometimes it’s a direct and obvious thing like the interest rate differentials which can drive forex rates. Other times it’s a bit more vague, like how interest rates are used in discounting cashflows for stock valuations, or in regards to carry costs in commodity markets.

These influences tend to be more general and slow changing, though. But there’s also a more direct and short-term relationship between stocks and interest rates. This is something which has become very much at the fore of the market action over the last year.

You see a large part of the stock/bond equation is asset allocation. When investors are feeling good they will tend toward equities. When worried, they will move toward fixed income. The more worried they are, the shorter term the fixed income. When the markets are really scared, money will flood into Treasury Bills. We saw alot of that in the last year during the market turmoils.

This is something one can use in short-term trading. I regularly watch what’s happening in 2 year Treasury rates to see how it matches up with what’s going on in stocks. Sometimes they can provide a leading indication as to what’s coming. Other times they either confirm stock price action or act as a divergent indictor to provide a warning. It’s quite useful.

One word of warning, though. The relationship between stocks and bonds is variable. Sometimes they go the same way. Sometimes not. It depends on the underlying reasons. For example, stocks would do well in an environment of strong growth, but bonds might not because of concerns about rising inflation. Be aware of what’s going on to make sure you are looking at things in the right context.

The Basics

Want to Learn Futures Trading?

The futures market is one that offers a great deal of opportunity to traders. If there’s a market out there, it can probably be traded through futures. Although a lot of folks think first of commodities (and indeed many still refer to futures as the commodities market), that is just a portion of what’s available.

Yes, through futures you can trade gold, oil, corn, suger, cotton, pork bellies, and other so-called hard commodities. You can also, however, trade all kinds of fixed income instruments like US T-Bonds, German Bunds, Eurodollars, and Short Sterling. Currencies can be traded via the futures market. So too can stock indices like the S&P 500, the NIKKEI, and the DAX. There are even futures on single stocks, not to mention a whole bunch of other markets you probably never even thought existed.

Futures trading is rather different than trading in stocks, though. In involves considerable leverage and the understanding of the deriviative instrument mechanism. It’s not as complicated as that might make it sound, though.

A while back - at the request of a futures broker friend of mine – I put together a guide to explain the ins and outs of futures trading and the futures market.

Click here to get a free introductory guide to help learn futures trading.