Trading & Its Features

Transcription

1 Trading & Its Features The buying and selling of futures contracts, equity shares, bonds and options is known as trading. There are several types of trading styles that persons seeking to profi t from short term trades in the market may wish to use. This white paper covers various types of trading and comparison among them. This paper also details the infrastructure required for online trading and types of instruments suitable for day trading. 1

2 About the Author ShanmugamSatheesh Kumar Shanmugam Satheesh Kumar is a Banking, Financial Services and Insurance (BFSI) Practice Consultant. He is currently working as a consultant at leading fi nancial institution in Switzerland in the area of master data administration. He has a Bachelor s degree in Physics from Bharathiar University, Coimbatore and a Masters degree in Computer Applications from the same university. 1

3 Table of Contents 1. Introduction 3 2. Basic Infrastructure Required for Online Traders 5 4. Instruments Suitable for Day Trading 6 5. Possible Trading in Different Geographies 7 6. Conclusion 8 2

4 Introduction The buying and selling of futures contracts, equity shares, bonds and options is known as trading. Trading is differentiated from investing by two factors. The fi rst is the time frame involved, as trading is completed often in minutes or hours, and very rarely more than weeks are involved, whereas investing is done for months or years, more of a long-term modest gain motivation. The second factor is the strategy used, which complements the fast timing of trading, as indicators are often used to help let a trader know when to get into or out of a particular position. There are several types of trading styles that persons seeking to profi t from short term trades in the market may wish to use. Here is a brief description of the most widely used trading types. Day trading Day traders buy and sell instruments whole day in the hope that the price of the instruments will fl uctuate in value during the day, allowing them to earn quick profi ts. A day trader will hold a instrument anywhere from a few seconds to a few hours, but will always sell all of those instruments before the close of each day. The day trader will therefore not own any positions at the close of any day, and there is overnight risk. The objective of day trading is to quickly get in and out of any particular instrument for a profi t anywhere from a few cents to several points per share on an intra-day basis. Day trading can be further subdivided into a number of styles, including: Scalpers: This type of day trading involves the fast and repeated buying and selling of a large volume of instruments within seconds or minutes. The objective is to earn a small per share profi t on each transaction while minimizing the risk. Momentum Traders: This type of day trading involves identifying and trading instruments that are in a moving pattern during the day, in an attempt to buy such instruments at bottoms and sell at tops. Swing trading The major difference between day trading and swing trading is that swing traders will normally have a slightly longer time horizon than day traders for holding a position in a instrument. As is the case with day traders, swing traders also attempt to predict the short term fl uctuation in an instrument s price. However, swing traders are willing to hold instruments for more than one day, if necessary, to give the instrument price some time to move or to capture additional momentum in the instrument s price. Swing traders will generally hold on to their instrument positions anywhere from a few hours to several days. Swing trading has the capability of providing higher returns than day trading. However, unlike day traders who liquidate their positions at the end of each day, swing traders assume overnight risk. There are some signifi cant risks in carrying positions overnight. For example news events and earnings warnings announced after the closing bell can result in large, unexpected and possibly adverse changes to an instrument s price. Position trading Position trading is very similar to swing trading, but with a longer time horizon. Position traders hold instruments for a time period anywhere from one day to several weeks or months. These traders seek to identify instruments where the technical trends suggest a possible large movement in price is likely to occur, but which may not be fully played out for several weeks or months. Online trading Online trading is not really properly described as a trading type. Rather, online trading is simply a term that refers to the medium used to enter and execute trades. Online traders, which can include long term investors, as well as day, swing and position traders, use either an Internet connection or a direct access online trading platform to access and execute trades with web based brokers. 3

5 Comparison of Online trading and Direct Access Trading There are two ways to day trade electronically, namely: 1. Conventional online trading using Internet browser and a Web based broker 2. Direct Access Trading systems using specialized software and a private network It is important for day traders to understand the key features of, and the differences between, these two forms of electronic trading. Conventional online brokers provide Web based trading whereby the client logs in through the broker s Web site and places orders through his Internet browser. By the time client loads his browser, waits for the broker s Web page to load, logs in, enters his order, and the broker reviews the order, several minutes may have elapsed. Further time may elapse before the order is actually executed after being received and reviewed by the online broker because several intermediaries may be involved in handling the order. In this regard, many online brokerage fi rms do not always themselves execute client orders directly, but rather may send the orders to other market makers for execution. This can result in slow execution of orders at a higher price than the client may have expected. This is bad news for day traders, as execution speed is critical for successful day trading. By way of contrast, Direct Access Trading (DAT) systems allow one to trade instrument directly with a market maker or a specialist on the fl oor of the exchange, using special trading software and high-speed computer linkages to the NASDAQ, NYSE and the various Electronic Communications Networks (ECNs). With a DAT trading platform, a trader may place orders directly into the market in real-time and trade directly with a market maker on NASDAQ, a specialist on the fl oor of the NYSE, or with an ECN, without any broker participation at all. There are no middle-men involved between the relevant stock exchanges, ECNs and the individual trader. If there is a sufficient number of a share available at the price specifi ed by the trader, the order is executed in a fraction of a second and a confi rmation is instantly displayed on the trader s computer screen. Because no middle-man is involved, the trader will save anywhere from a few seconds to several minutes of time to complete a typical trade. Accordingly, the major advantage of a DAT system is that it results in much faster executions than one can normally achieve using a conventional online broker. In summary, as compared with conventional online brokers, day trading fi rms offer better access to the markets, much faster executions, and greater control in order routing. Proprietary trading This is trading by a bank/securities fi rm on its own account and not for any client. Proprietary traders can only trade on their own account and generally they have limited shareholders funds. Proprietary traders are linked to locals or professional traders participating on the fl oor of derivative exchanges. The emergence and growth of electronic markets has enabled them to create companies that access as many markets as they wish from a single location. Proprietary traders are usually leaders in the ranking by traded volume on the main derivative exchanges in the world and represent one of the main generators of liquidity for the markets. 4

6 Basic infrastructure required for online traders The basic equipment and services required by serious day traders to enable them to put together an adequate platform for online day trading. It is crucial for an active day trader to spend the money necessary to create a solid trading platform in order to compete on the same level with market makers and other day traders. Minimum Hardware Requirements The only items of hardware that you require to trade online are a properly confi gured computer and a monitor. In this regard, a 1000MHZ computer with 512MB of RAM, a 100 Gigabyte hard drive and a high quality video card is adequate, but the higher the processor speed the better. The monitor should be at least 17, and preferably larger. Depending on the type of online connection is chosen, the computer should be equipped with either a 56K modem or (preferably) a high speed network card with a cable or DSL modem. Based on current prices, an outlay of about $25,000 for the basic hardware items outlined above should be suffi cient to get started. Connection Speed Online connection speed is a very important consideration for active day traders who need fast order executions, confi rmations of trades and delivery of news, quotes and other market data. A 56K modem dial-up connection is barely adequate for the less active trader. For the active day trader, a cable modem connection or a DSL phone line connection is highly recommended. Expect to pay about $500 a month for regular dial-up Internet service and between $1200 $2000 a month for a cable or DSL phone connection. Real time data In order to successfully day trade, it is must to have access to real-time market data. Relying on stale information will result in poor trades. The types of data a day trader should have real-time access to include the following: Stock quotes and ticker Market averages and indices Market news stories Charting Price and news alerts Online order execution There are two basic types of online order execution services available to day traders and other investors. The fi rst type of service is offered by Internet based online discount brokers such as E*trade or Waterhouse Securities. This is by far the most commonly used type of online trading service. The second type of service is provided through online systems that link the customer directly to the relevant exchange through a modem or dedicated phone line. These systems are generally referred to as Electronic Direct Access Trading (EDAT). Internet based discount brokers vary in how they execute customer orders and the length of time it takes them to review, execute or confi rm trade orders. Some fi rms choose to route certain orders to another broker or third party for execution. This can delay the time it takes to complete a trade. Also, few of these brokers offer to route orders to an Electronic Communications Network (ECN) where the price may be better and fewer still offer services such as NASDAQ Level II quotes. Consequently, for active day traders who want instant confi rmations, NASDAQ Level II quotes, and direct access to exchanges and ECNs, an EDAT system is preferable to trading through a traditional Web based online broker, even though commission rates and other fees may be higher. An EDAT system will enable the day trader to have direct contact with specialists on the fl oor of the New York Stock Exchange, the market makers on NASDAQ and the various ECNs. An EDAT system permits a trader 5

7 to place an order directly into the market resulting in much quicker order executions and confi rmations than is generally the case with Internet based discount brokers and often at better prices. Instruments suitable for day trading The most important basic characteristics an instrument should have in order to make a suitable candidate for potential day trading are listed below: Liquidity Volume Volatility Price Transparency Each of the above attributes are discussed separately in the below sub-sections. Liquidity Liquidity, broadly defi ned, is the existence of a suffi ciently large number of buyers and sellers in a instrument to permit one to quickly and easily acquire or exit a position in the instrument. Good liquidity is important to the day trader who requires fast executions at relatively predictable prices. High liquidity also has the additional advantage of (generally) reducing the bid-ask spread for a particular instrument therefore reducing execution costs for the day trader. There is no quantitative measure of liquidity. Liquidity is based on a number of factors, the most important of which are: Volume of transactions on the market (the higher the better) Number of shares outstanding (the more the better) Breadth of ownership ( the higher the number of shareholders the better) Number of market makers (the more the better) Most of the instruments of the larger companies on NASDAQ and the NYSE will have a suffi cient degree of liquidity to make them potential day trading candidates. This is particularity true of instruments included in the major indexes such as the Dow Jones Industrials or NASDAQ 100. On the other hand, relatively few small-cap companies would have suffi cient liquidity to be attractive to most day traders. Volume Volume is a component of liquidity and is easily measurable. A good day trading instrument should trade at least 500,000 shares a day and preferably much more. Instruments with high volumes permit the day trader to acquire or sell a large quantity of instrument without unduly affecting the price of the instrument. Volatility Volatility refers to the actual or expected price movement of a instrument (either up or down) over a particular period of time. In the case of day trading, the period of time to look at is a single day. Instruments which tend to exhibit little movement in price during a typical trading day are not good candidates for day trading. A good rule of thumb is to select for trading only those instruments which tend to fl uctuate in price by at least $ 100 in a typical trading day. Price Transparency Price transparency refers to the ability to obtain information as to the order fl ow for a particular instrument. This is also referred to as market depth. The NASDAQ II quote system provides information on all the bids and asks at various price levels for a particular instrument and not just the inside market quote (i.e. the highest ask and lowest bid). In addition, the quantities of instrument being offered and bid for at the various price levels are made available. For day traders who have arranged for access to NASDAQ Level II quote screens, this greatly helps the trader in assessing the relative strength or weakness of a instrument and its likely direction in price. 6

8 By way of contrast, NYSE quotes display only the highest bid and lowest ask prices. Only the specialist (market maker) responsible for handling orders in a particular NYSE instrument has knowledge of the complete order fl ow for the instrument. Accordingly, many day traders prefer to trade only NASDAQ instruments. This is not to suggest that NYSE instruments are not good candidates for day trading under certain circumstances. However, there is less price transparency on this exchange than on NASDAQ. Possible trading in different geographies The types of trading will vary in each geographical location. The below table provides possible types of trading in each geography. 7

9 Conclusion Many day traders are comfortable conducting their trading activities from an offi ce in their home. However, for those day traders who aspire to make a full-time career day trading, there are a number of benefi ts to trading on the premises of a day trading fi rm rather than from home. The principal advantages to trading in-house at a good day trading fi rm are the availability of structured training programs, top of the line trading software, hardware and data feeds as well as the ability to interact with and learn from other professional traders. It is important to keep in mind that day trading fi rms who offer in-house training and trading services differ signifi cantly in the range and quality of the services they provide as well as in their fee structures. Accordingly, it is wise to perform some due diligence prior to selecting a fi rm to trade at. 8

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