Chapter 3
Signing Up for Asset Classes
IN THIS CHAPTER
Finding good assets for day trading
Seeking securities to trade
Counting cash and currency
Making money from mundane commodities
Deriving profits from derivatives
It’s one thing to day trade, but what are you going to trade? Stocks, pork bellies, or hockey cards? You have myriad choices, but you have to choose so that you can learn the market, know what changes to expect, and make your trades accordingly.
Although it may be tempting, you can’t trade everything. There are only so many hours in a day and only so many ideas you can hold in your head at any one time. Furthermore, some trading strategies lend themselves better to certain types of assets than others. By learning more about all the various investment assets available to a day trader, you can make better decisions about what you want to trade and how you want to trade it.
What Makes a Good Day Trading Asset?
In academic terms, the universe of investable assets includes just about anything you can buy at one price and sell at another, potentially higher price. That means artwork and collectibles, real estate, and private companies would all be considered to be investable assets.
Day traders have a much smaller group of assets to work with. It’s not realistic to expect a quick one-day profit on price changes in real estate. Online auctions for collectible items take place over days, not minutes. If you’re going to day trade, you want to find assets that trade easily, several times a day, in recognized markets. In other words, you want liquidity. As an individual trading your own account, you want assets that can be purchased with relatively low capital commitments. And finally, you may want to use leverage — borrowed money — to improve your return, so you want to look for assets that can be purchased using other people’s money.
Liquidity
Liquidity is the ability to buy or sell an asset in large quantity without affecting the price levels. Day traders look for liquid assets so they can move in and out of the market quickly without disrupting price levels. Otherwise, they may not be able to buy at a good price or sell when they want.
At the most basic level, financial markets are driven by supply and demand. The more of an asset supplied in the market, the lower the price; the more of an asset that people demand, the higher the price. In a perfect market, the amount of supply and demand is matched so that prices don’t change. This happens if a high volume of people are trading, so that their supply and demand is constantly matched, or if a very low frequency of trades are happening, so that the price never changes.
You may be thinking, Wait, don’t I want big price changes so that I can make money quickly? Yes, you want price changes in the market, but you don’t want to be the one causing them. The less liquid a market is, the more likely your buying and selling is going to affect market prices, and the smaller your profit will be.
Volume
Volume is the total amount of a security that trades in a given time period. The greater the volume, the more buyers and sellers are interested in the security, and the easier it is to get in there and buy and sell without affecting the price.
Day traders also look at the relationship between volume and price. This is an important technical indicator. The simple version is this:
- High volume with no change in price levels means an equal match between buyers and sellers.
- High volume with rising prices means more buyers than sellers, so the price will continue going up.
- High volume with falling prices means more sellers than buyers, so the price will keep going down.
Frequency
Another measure of liquidity is frequency, or how often a security trades. Some assets, like stock market futures, trade constantly, from the moment the market opens until the very last trade of the day, and then continue into overnight trading. Others, like agricultural commodities, trade only during market hours or only during certain times of the year. Other securities, like stocks, trade frequently, but the volume rises and falls at regular intervals related to such things as options expiration (the date at which options on the stock expire).
The more frequently a security trades, the more opportunities you’ll have to identify the short-term profit opportunities that make day trading possible.
Volatility, standard deviation, and variance
The volatility of a security is how much the price varies over a period of time. It tells you how much prices fluctuate and thus how likely you are to be able to take advantage of that. For example, if a security has an average price of $5 but trades anywhere between $1 and $14, it will be more volatile than one with an average price of $5 that trades between $4 and $6.
One standard measure of volatility and risk is standard deviation, which is how much any given price quote varies from a security’s average price. You can calculate it with most spreadsheet programs and many trading platforms.
For each of the prices, you calculate the difference between it and the average value. So if the average price is $5, and the closing price today is $8, the difference would be $3. (More likely, the research service that you use would calculate the difference for you.)
After you have all the differences between the prices and the average, you find the square of these differences. If the difference for one day’s price is $8, then the square would be $64. You add up all the squared differences over the period of time that you’re looking at and then find the average of them. That number is called the variance. Finally, calculate the square root of the variance, and you have the standard deviation.
The higher the standard deviation, the higher the volatility; the higher the volatility, the more a security’s price is going to fluctuate, and the more profit — and loss — opportunities exist for a day trader.
Standard deviation is also a measure of risk that can be used to evaluate your trading performance.
Capital requirements
You don’t necessarily need a lot of money to begin day trading, but you do need a lot of money to buy certain securities. Stocks generally trade in round lots, which are orders of at least 100 shares. For example: If you want to buy a stock worth $40 per share, you need $4,000 in your account. Your broker will probably let you borrow half of that money, but you still need to come up with the other $2,000.
Options and futures trade by contract, and one contract represents some unit of the underlying security. For example, in the options market, one contract is good for 100 shares of the stock. These contracts also trade in round lots of 100 contracts per order.
No one will stop you from buying a smaller amount than the usual round lot in any given security, but you’ll probably pay a high commission and get worse execution for your order. Because the returns on each trade tend to be small anyway, don’t take up day trading until you have enough money to trade your target asset effectively. Otherwise, you’ll pay too much to your broker without getting much for yourself.
Bonds do not trade in fractional amounts; they trade on a per-bond basis, and each bond has a face value of $1,000. Some trade for more or less than that, depending on how the bond’s interest rate differs from the market rate of interest, but the $1,000 is a good number to keep in mind when thinking about capital requirements. Many dealers have a minimum order of 10 bonds, though, so a minimum order would be $10,000.
Marginability
Most day traders make money through a large volume of small profits. One way to increase the profit per trade is to use borrowed money in order to buy more shares, more contracts, or more bonds. Margin is money in your account that you borrow against, and almost all brokers will be happy to arrange a margin loan for you, especially if you’re going to use the money to make more trades and generate more commissions for the brokerage firm.
Generally, a stock or bond account must hold 50 percent of the purchase price of securities when you borrow the money. So if you want to buy $100 worth of something on margin, you need to have $50 in your account. The price of those securities can go down, but if they go down so much that the account now holds only 30 percent of the value of the loan, you’ll get a margin call.
In Canada, margin requirements for each security are set by the Canadian regulators, though brokerage firms sometimes set their own, higher amounts. There are no rules that limit the maximum amount of money you can borrow, but the brokerage firms will lose a lot of money if you don’t pay them back. That’s why they may set a limit on the loan. Each firm has its own rules, so check with your broker on how they set their margin requirements.
You probably think that the 1929 crash was responsible for the Great Depression of the 1930s, right? Think again. Most economic historians believe that the crash was a distraction. Instead, the real problem was that interest rates fell so rapidly that banks refused to lend money, while prices fell so low that companies had no incentive to produce. It’s a situation known as deflation, and it’s relatively rare, but it is devastating when it occurs.
Most stocks and bonds are marginable (able to be purchased on margin), and the Investment Industry Regulatory Organization of Canada (IIROC) allows traders to borrow up to 70 percent — you have to put at least 30 percent down — of their value. But not all securities are marginable. Stocks priced below $5 per share, those traded on the OTC Bulletin Board (discussed later in this chapter), and those in newly public companies often cannot be borrowed against or purchased on margin. Your brokerage firm should have a list of securities that are not eligible for margin.
If leverage is going to be part of your day trading strategy, be sure the assets you plan to trade are marginable.
Securities and How They Trade
In the financial markets people buy and sell securities every day, but just what are they buying or selling? Securities are financial instruments. In the olden days, they were pieces of paper, but now they are electronic entries that represent a legal claim on some type of underlying asset. This asset may be a business, if the security is a stock, or it may be a loan to a government or a corporation, if the security is a bond. This section covers different types of securities that day traders are likely to run across and tells you what you need to jump into the fray.
In practice, asset and security are synonyms, and derivative is considered to be a type of asset or security. But to be precise, these three are not the same:
- An asset is a physical item. Examples include a company, a house, gold bullion, or a loan.
- A security is a contract that gives someone either the right of ownership of an asset, such as a share of stock, or a promissory note that is in turn backed by an asset, such as a bond.
- A derivative is a contract that draws its value from the price of a security.
Stocks
A stock, also called an equity, is a security that represents a fractional interest in the ownership of a company (see Book 2 for the full scoop). Buy one share of Microsoft, and you’re an owner of the company, just as Bill Gates is. He may own a much larger share of the total business, but you both have a stake in it. Shareholders elect a board of directors to represent their interests in how the company is managed. Each share is a vote.
A share of stock has limited liability. That means you can lose all your investment, but no more than that. If the company files for bankruptcy, the creditors cannot come after the shareholders for the money they are owed.
Some companies pay their shareholders a dividend, which is a small cash payment made out of firm profits. Because day traders hold stock for really short periods of time, they don’t normally collect dividends.
How stocks trade
Stocks are priced based on a single share, and most brokerage firms charge commissions on a per-share basis. Despite this per-share pricing, stocks are almost always traded in round lots of 100 shares. The supply and demand for a given stock is driven by the company’s expected performance.
A stock’s price is quoted with a bid and an ask:
- The bid is the price that other buyers will buy the stock from you if you’re selling.
- The ask is the price that other sellers will sell you if you’re the one buying.
Bid-ask prices on Canadian exchanges are a centralized quote — they represent the best bid and ask prices from all participants on the market. In the U.S. it’s the broker who sets the bid ask price — and often profits off the spread — but in Canada quotes are posted for everyone to see regardless of broker.
Here’s an example of a price quote:
MSFT $27.70 $27.71
That’s a quote for Microsoft (ticker symbol: MSFT on the Nasdaq). The bid is listed first: $27.70; the ask is $27.71. That’s the smallest spread you’ll ever see! The spread here is so small because Microsoft is a liquid stock, and no big news events at the moment might change the balance of buyers and sellers.
If your American trading buddy is talking about how his broker takes a cut of the spread, don’t panic and wonder why you haven’t noticed those same fees. In Canada brokers make money off commission — it’s unlikely they’re taking a percentage of the spread.
People tend to use the words broker and dealer interchangeably, but a difference does exist. A broker simply matches buyers and sellers of securities, whereas a dealer buys and sells securities out of its own account. Almost all brokerage firms are both brokers and dealers.
Where stocks trade
Stocks trade mostly on organized exchanges such as the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE), but more and more they trade on electronic communications networks, also called alternative trading systems, some of which are operated by the exchanges themselves. Brokerage firms either belong to the exchanges themselves or work with a correspondent firm that handles the trading for them, turning over the order in exchange for a cut of the commission.
When you place an order with your brokerage firm, the broker’s trading staff executes that order wherever it can get the best deal. But is that the best deal for you? You’ll be happy to know, that yes it is. Canadian dealers have an obligation to get the best execution for their client — it’s written right in the rules set out by the regulators.
The financial markets are in a state of flux, with a lot of mergers and acquisitions among the exchanges. The information here might be obsolete when you read it, which really is fascinating. It wasn’t so long ago that these exchanges were staid organizations run like private clubs.
TORONTO STOCK EXCHANGE (TSX)
The TSX is the Canadian exchange. If a Canadian company wants the public’s cash, it’s going to list on the TSX — and almost all major corporations in the Great White North do. However, not all companies can trade on the exchange — you definitely won’t see the corner store take out an IPO, and even larger businesses can’t automatically list. More than 1,570 companies are listed on the exchange, with a total market cap — the total dollar market value of a company’s outstanding shares — of more than $3.1 trillion.
All the companies listed on the exchange paid a fee to be there. Depending on the size of the company, businesses have to pay between $10,000 and $200,000 to list. In most cases companies are assigned a three-letter ticker symbol — BlackBerry (originally called Research In Motion) uses RIM, for example — but not always. Gold company Kinross’s symbol is, appropriately, K, and Toronto Dominion Bank can be found under TD. Some companies, like Toronto-based media company Torstar, have a “.B” after their symbol (TS.B), which means investors can purchase only non-voting class B shares.
Companies have to meet a number of requirements to list, and the requirements vary depending on the industry. You can find out all about the wonderful world of listing at www.tmx.com, but here are the basics: Company execs have to show they’re successful, or, if it’s a new venture, that the management has a record of experience. Companies must also have a certain amount of assets, though it varies per sector.
TSX VENTURE EXCHANGE (TSXV)
The Calgary-based TSX Venture Exchange operates like the TSX, but it’s for junior companies or new businesses looking for startup capital. More than 1,600 companies are listed on the exchange, with a total market cap of $45 billion. The mining industry makes most use of the TSXV — 56 percent of the companies are from that sector — and technology companies come in a distant second. Some of these companies will eventually move to the TSX, and others will close shop and delist. Because it’s mostly for smaller operations it’s a slightly more volatile place to invest.
The TSXV is a good place for traders to play resource-based companies, because that’s what makes up most of the index.
ALTERNATIVE TRADING SYSTEMS (ATS) AND ELECTRONIC COMMUNICATION NETWORKS (ECN)
Once upon a time the TSX was the only exchange in town. That monopoly meant it could charge brokers high fees for trades. And, if something went wrong with the TSX’s software — like it did in December 2008, when a technical glitch cancelled an entire day of trading — investors would be out of luck. Alternative trading systems, also called electronic communication networks, have been around since the turn of the century, but only in the last decade have they begun to be a viable alternative to the standard exchanges.
Canada has a number of alternative trading systems — Chi-X Canada and Omega ATS, to name a couple — and all list the exact same securities as the TSX, but at different prices. Share prices don’t vary too much, though; RIM’s open price could be $46.15 and Omega ATS lists it at $46.50. Luckily, traders don’t have to worry about the different exchanges because the broker will automatically sort through every exchange and buy the stock at the best price. A good chance exists you won’t even know that you purchased a stock on Chi-X instead of the TSX.
Some traders swear like sailors as they rapidly buy and sell, but one F-word is worse than anything you’d hear a few minutes to close: fees. Brokers have to pay them every time they trade, and those costs are often passed down to the trader. When the TSX had a monopoly it could charge whatever it wanted; alternative trading systems were created in part to bring those fees down. Fortunately, fees have fallen, and as alternative trading systems gain more ground they could drop more. That’s good news for traders who will hopefully see commission costs tumble as brokers pass on their savings to their customers.
THE NEW YORK STOCK EXCHANGE (NYSE)
Why is an American exchange listed in a Canadian day traders book? Because most day traders spend money on U.S. exchanges. It’s important to know just as much about them — if not more — than the TSX. The New York Stock Exchange is the Big Kahuna of stock exchanges. Most of the largest U.S. corporations trade on it, and, like the TSX, they pay a fee for that privilege. The more than 2,000 companies listed on the exchange also have ticker symbols with three or fewer letters; many old companies have one-letter symbols, like F for Ford and T for AT&T.
To be listed on the New York Stock Exchange, a company generally needs to have at least 2,200 shareholders, trade at least 100,000 shares a month, carry a market capitalization (number of shares outstanding multiplied by price per share) of at least $100 million, and post annual revenues of at least $75 million.
The New York Stock Exchange is more than 200 years old, and has been going through some big corporate changes in order to stay relevant. Unlike its Canadian counterpart, it’s a floor-based exchange. The trading area is a big open space in the building, known as the floor. The floor broker, who works for the member firm, receives the order electronically and then takes it over to the trading post, which is the area on the floor where the stock in question trades. At the trading post, the floor broker executes the order at the best available price.
NYSE AMERICAN
NYSE American, once known as the American Stock Exchange (AMEX), is a floor-based exchange also headquartered in New York City. Like the New York Stock Exchange, floor brokers receive orders and take them to trading posts to be filled. NYSE American specializes in growing companies, but some other types of businesses are also listed on it. Listed companies have two- or three-letter ticker symbols and generally are profitable, have a market capitalization (number of shares outstanding multiplied by price per share) of at least $75 million, and have a price per share of at least $2. These companies tend to be smaller and more speculative than New York Stock Exchange companies.
NASDAQ
Nasdaq used to stand for the National Association of Securities Dealers Automated Quotation System, but now it’s just a name, not an acronym, pronounced just like it’s spelled. When Nasdaq was founded, it was an electronic communication network (more on those earlier in this chapter) that handled — like the TSXV — companies that were too small or too speculative to meet New York Stock Exchange listing requirements. What happened was that brokers liked using the Nasdaq network, while technology companies (like Microsoft, Intel, Oracle, and Apple) that were once small and speculative became international behemoths. But the management teams of these companies saw no reason to change how they were listed.
Nasdaq companies have four-letter ticker symbols. When a customer places an order, the brokerage firm looks to see whether a matching order is on the network. Sometimes, it can be executed electronically; in other cases, the brokerage firm’s trader needs to call other traders at other firms to see whether the price is still good. A key feature of Nasdaq is its market makers, who are employees of member brokerage firms who agree to buy and sell minimum levels of specific stocks in order to ensure some basic level of trading is taking place.
Nasdaq divides its listed companies into three categories:
- The Nasdaq Global Select Market includes the 1,400 largest companies on the exchange and has high governance and liquidity standards for participating firms.
- The Nasdaq Global Market includes companies that are too small for the Global Select Market, but that in general have a market capitalization of at least $75 million, at least 1.1 million shares outstanding, at least 400 shareholders, and a minimum price per share of $5.
- The Nasdaq Capital Market is for companies that do not qualify for the Nasdaq Global Market. To qualify here, companies need a market capitalization of at least $50 million, at least one million shares outstanding, about 300 shareholders, and a minimum price per share of $4.
Day traders will find that Nasdaq Global Select Market companies are the most liquid. They may also notice changes in trading patterns when a company is close to being moved between categories. An upgrade is a sign of good news to come and increased market interest. A downgrade means that the company most likely isn’t doing well and will be of less interest to investors.
OVER-THE-COUNTER BULLETIN BOARD (OTC BB)
The Over-the-Counter Bulletin Board is the market for companies that are reporting their financials to the provincial securities commissions (and, in the States, the U.S. Securities and Exchange Commission) but that do not qualify for listing on the TSXV or Nasdaq. Canada’s OTC market is tiny; you can buy these types of companies on the TMX Group–run NEX. The exchange is for companies that have low levels of business activity or aren’t active anymore. In other words, they’re too small to trade on other exchanges.
In many cases, a Bulletin Board listing is often a last hurrah before oblivion.
Bonds
A bond is a loan. The bond buyer gives the bond issuer money. The bond issuer promises to pay interest on a regular basis. The regular coupon payments are why bonds are often called fixed income investments. Bond issuers repay the money borrowed — the principal — on a predetermined date, known as the maturity. Bonds generally have a maturity of more than ten years; shorter-term bonds are usually referred to as notes, and bonds that will mature within a year of issuance are usually referred to as bills. Most bonds in North America are issued by corporations (corporate bonds) or by the federal governments (called government bonds in Canada and Treasury bonds in the States). Some local governments in the U.S. also issue municipal bonds, but that’s much less common in Canada.
The interest payments on a bond are called coupons. You’ve probably seen “car for sale” or “apartment for rent” signs with little slips of paper carrying a phone number or e-mail address cut into the bottom. If you’re interested in the car or the apartment, you can rip off the slip and contact the advertiser later. Bonds used to look the same. The bond buyer would receive one large certificate good for the principal, with a lot of smaller certificates, called coupons, attached. When a payment was due, the owner would cut off the matching coupon and deposit it in the bank. (Some old novels refer to rich people as “coupon clippers,” meaning that their sole labour in life was to cut out their bond coupons and cash them in. Nowadays, bond payments are handled electronically, so the modern coupon clipper is a bargain hunter looking for an extra 50 cents off a jar of peanut butter.)
Over the years, enterprising financiers realized that some investors needed regular payments, but others wanted to receive a single sum at a future date. So they separated the coupons from the principal. The principal payment, known as a zero-coupon bond, is sold to one investor, while the coupons, called strips, are sold to another investor. The borrower makes the payments just like with a regular bond. (Regular bonds, by the way, are sometimes called plain vanilla.)
The borrower who wants to make a series of payments with no lump-sum principal repayment would issue an amortizing bond to return principal and interest on a regular basis. If you think about a typical mortgage, the borrower makes a regular payment of both principal and interest. This way, the amount owed gets smaller over time so that the borrower does not have to come up with a large principal repayment at maturity.
Other borrowers would prefer to make a single payment at maturity, so they issue discount bonds. The purchase price is the principal reduced by the amount of interest that otherwise would be paid.
If a company goes bankrupt, the bondholders get paid before the shareholders. In some bankruptcies, the bondholders take over the business, leaving the current shareholders with nothing. See Chapter 5 in Book 3 for more about bonds.
How bonds trade
Bonds often trade as single bonds, with a face value of $1,000, although some brokers will only take on minimum orders of ten bonds. They don’t trade as frequently as stocks do because most bond investors are looking for steady income, so they hold their bonds until maturity. Bonds have less risk than stocks, so they show less price volatility. The value of a bond is mostly determined by the level of interest rates in the economy. As rates go up, bond prices go down; when rates go down, bond prices go up. Bond prices are also affected by how likely the loan is to be repaid. If traders don’t think that the bond issuer will pay up (that is, perceive default risk), then the bond price will fall.
Generally speaking, only corporate (and municipal in the U.S.) bonds have repayment risk. It’s possible that the U.S. government could default, but that’s unlikely as long as it can print money. Most international government bonds have similarly low default risk, but some countries have defaulted, especially when they borrow in foreign currencies. The most notable was Russia, which refused to print money to repay its debts in the summer of 1998. This caused huge turmoil in the world’s financial markets, including the collapse of a major hedge fund, Long-Term Capital Management.
The global financial crisis also put many countries at risk, especially in Europe. In 2010 fears spread that Greece would default on its loans after Standard & Poor’s — a U.S.-based company that rates borrowers — downgraded the country’s debt rating to junk bond status. That sent stock markets plunging and spread fear that other financially strapped European countries, like Spain and Portugal, would default too. So, as you can see, just because a bond is issued by a government doesn’t mean your investment is guaranteed.
In the past, investment banks and governments would sell new bonds directly to institutional investors, like pension plans or mutual funds. Now, anyone can buy bonds — but because they are usually purchased in large quantities, it’s rare that a retail investor would buy a few bonds to complement her stocks. Traders, though, have more access to the bond market thanks to their broker. The broker will buy hundreds of thousands of dollars in bonds (or much more) and then sell them piecemeal to traders. Most bonds trade over-the-counter, meaning dealers trade them among themselves rather than on an organized exchange.
A bond price quote looks like this:
3 3/4 Mar 21 n 99:28 99:29
This is a U.S. Treasury note maturing in March 2021 carrying an interest rate of 3.75 percent. Similar to stocks, the numbers right after the “n” (for note) list the bid and ask.
- The first number is the bid, and it’s the price at which the dealer will buy the bond from you if you’re selling.
- The second number is the ask, and it’s the price the dealer will charge you if you’re buying. The difference is the spread, and that’s the dealer’s profit.
But wait, there’s more: Corporate bonds trade in eighths of a percentage point, and government bonds trade in 32nds. The bid of 99:28 means that the bond’s bid price is 99
percent of the face value of $1,000, or $998.75.
Why on earth do bonds trade in eighths or fractions of eighths? Do traders just like to show off their math skills? No, it goes back to before the American Revolution. The dominant currency in most of the Americas then was the Spanish doubloon, a large gold coin that could be cut into fractions to make trade easier. Like a pie, it would be cut into eight equal pieces, so prices throughout the colonies were often set in eighths. (In Robert Louis Stevenson’s book Treasure Island, the parrot keeps squawking “Pieces of eight! Pieces of eight!” This is why.)
The fractional pricing convention carried over to North American securities markets, and has persisted because it guarantees dealers a bigger spread than pricing in decimals. After all, 1⁄32 of a dollar is more than 
. U.S. and Canadian stocks were priced in sixteenths until 2001. You’ll notice a difference between the U.S. and Canadian bond markets, though. If you’re purchasing an American bond it will be priced using the old convention, but buy a Canadian bond and you’ll be dealing in decimals.
Most bonds are not suitable for day traders. Only government bonds have enough consistent trading volume to attract a day trader. Because of the capital required to trade and the relatively low liquidity of many types of bonds, many traders prefer to use futures to bet on interest rates. Futures are discussed in detail later in this chapter.
Where bonds trade
Are you one of those day traders who wants to buy or sell bonds anyway? Or do you just want to know more about the market? Then read on:
- Listed bonds: Some larger corporate bonds are traded on the TSX, the New York Stock Exchange, and NYSE American. When you want to buy or sell them, you place an order through your brokerage firm, which sends an order to the floor broker. The process is almost identical to the trading of listed stocks.
- Over-the-counter trading: Most corporate and municipal bonds trade over-the-counter, meaning no organized exchange exists. Instead, brokerage firms use electronic price services to find out where the buyers and sellers are for different issues. Over-the-counter bonds don’t trade much. Buyers often give their quality, interest rate, and maturity requirements to their broker, and the broker waits until a suitable bond comes to market.
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Treasury dealers: Unlike the corporate and municipal bond market, the Treasury market is one of the most liquid in the world. The best way to buy a new Treasury bond is directly from the government, because no commission is involved. You can get more information from the government of Canada’s website,
https://www.canada.ca/en/department-finance/programs/financial-sector-policy/securities/debt-program.html, or the U.S. Treasury Department’s website,www.savingsbonds.gov. Both have information on different government bonds for various purchasers. Note that you can no longer buy bonds from the Canadian government, which stopped selling them in 2017, but the website has information on what to do if you already own them.After the bonds are issued, they trade on a secondary market of Treasury dealers. These are large brokerage firms registered with the government that agree to buy and sell bonds and maintain a stable market for the bonds. If your brokerage firm is not a Treasury dealer, it has a relationship with one that it can send your order to.
Treasury dealers do quite a bit of day trading in Treasury bonds for the firm’s own account. After all, the market is liquid enough that day trading is possible. Few individual day traders work the Treasury market, though, because it requires a great deal of capital and leverage to make a high return.
Exchange traded funds (ETFs)
Exchange traded funds (ETFs) are a cross between mutual funds and stocks, and they offer a great way for day traders to get exposure to market segments that might otherwise be difficult to trade. A money management firm buys a group of assets — stocks, bonds, or others — and then lists shares that trade on the market. (One of the largest organizers of exchange traded funds is Blackrock’s iShares at www.ishares.com.) In most cases, the purchased assets are designed to mimic the performance of an index, and investors know what those assets are before they purchase shares in the fund.
Exchange traded funds are available on the big market indexes, like the S&P/TSX Composite Index, the S&P/TSX 60, the S&P 500, and the Dow Jones Industrial Average. They are available in a variety of domestic bond indexes, international stock indexes, foreign currencies, and commodities. (Flip to Chapter 4 in Book 3 for more information on ETFs.)
For day traders, the advantage of exchange traded funds is that they can be bought and sold just like stocks, discussed earlier in this chapter. Customers place orders, usually in round lots, through their brokerage firms. The price quotes come in decimals and include a spread for the dealer.
The firm that sets up the exchange traded fund gets to choose the market where it will trade, as long as the fund meets the exchange’s requirements for size, liquidity, and financial reporting. Exchange traded funds trade on the TSX, NYSE, NYSE American, and Nasdaq.
Cash and Currency
Cash is king, as they say. It’s money that’s readily available in your day trading account to buy more securities. For the most part, the interest rate on cash is very low, but if you’re closing out your positions every night, you’ll always have a cash balance in your brokerage account. The firm will probably pay you a little interest on it, so it will contribute to your total return.
Money market accounts are boring. For day trading excitement, cash can be traded as foreign currency. Every day, trillions (yes, that’s trillions with a t) of dollars are exchanged, creating opportunities to make money as the exchange rates change. Currency is a bigger, more liquid market than the U.S. stock and bond markets combined. It’s often referred to as the forex market, short for foreign exchange.
How currency trades
The exchange rate is the price of money. It tells you how many dollars it takes to buy yen, pounds, or euros. The price that people are willing to pay for a currency depends on the investment opportunities, business opportunities, and perceived safety in each nation. If American businesses see great opportunities in Thailand, for example, they’ll have to trade their dollars for baht in order to pay rent, buy supplies, and hire workers there. This will increase the demand for baht relative to the dollar, and it will cause the baht to go up in price relative to the dollar.
Exchange rates are quoted on a bid-ask basis, just as are bonds and stocks. A quote might look like this:
USDJPY=X 118.47 118.50
This is the exchange rate for converting the U.S. dollar into Japanese yen. The bid price of 118.47 is the amount of yen that a dealer would give you if you wanted to sell a dollar and buy yen. The ask price of 118.50 is the amount of yen the dealer would charge you if you wanted to buy a dollar and sell yen. The difference is the dealer’s profit, and naturally, you’ll be charged a commission, too.
Note that with currency, you’re a buyer and a seller at the same time. This can increase the profit opportunities, but it can also increase your risk.
Day traders can trade currencies directly at current exchange rates, which is known as trading in the spot market. They can also use currency exchange traded funds (discussed earlier in this chapter) or currency futures (discussed later in this chapter) to profit from the changing prices of money.
Where currency trades
Spot currency — the real-time value of money — does not trade on an organized exchange. Instead, banks, brokerage firms, hedge funds, and currency dealers buy and sell among themselves all day, every day.
Day traders can open dedicated forex accounts through their broker or a currency dealer (one is https://forex.ca/) and then trade as they see opportunities during the day.
How the Canadian dollar is traded
The most common currency transaction is the euro against the U.S. dollar, mainly because Europe is one of the largest trading blocs in the world and a lot of business is done between those two countries. But Canadians often trade the loonie against the greenback for two reasons: America’s our biggest trading partner, and it’s just what we know. You can, of course, trade the Canadian dollar against any other currency too.
Beginners may want to stick to the Canada–U.S. relationship, simply because most news outlets in the Great White North report on currency fluctuations relative to the American buck. Understanding how to trade the loonie against the yen takes a bit more work.
Commodities and How They Trade
Commodities are basic, interchangeable goods sold in bulk and used to make other goods. Examples include oil, gold, wheat, and lumber. Commodities are popular with investors as a hedge against inflation and uncertainty. Stock prices can go to zero, but people still need to eat! Although commodity prices usually tend to increase at the same rate as in the overall economy, so they maintain their real (inflation-adjusted) value, they can also be susceptible to short-term changes in supply and demand. A cold winter increases demand for oil, a dry summer reduces production of wheat, and a civil war could disrupt access to platinum mines.
Day traders aren’t going to buy commodities outright — if you really want to haul bushels of grain around all day, you can do that without taking on the risks of day trading. You’d get more exercise, too. Instead, day traders who want to play with commodities can look to other investments. The most popular way is to buy futures contracts, which change in price with the underlying commodity (discussed later in this chapter). Increasingly, many trade commodities through exchange traded funds (covered earlier in this chapter) that are based on the value of an underlying basket of commodities.
Derivatives and How They Trade
Derivatives are financial contracts that draw their value from the value of an underlying asset, security, or index. For example, an S&P/TSX 60 futures contract would give the buyer a cash payment based on the price of the S&P/TSX 60 index on the day that the contract expires. The contract’s value thus depends on where the index is trading. You’re trading not the index itself, but rather a contract with a value derived from the price of the index. The index value changes all the time, so day traders have lots of opportunities to buy and sell.
Types of derivatives
Day traders are likely to come across three types of derivatives. Options and futures trade on dedicated derivatives exchanges, whereas warrants trade on stock exchanges.
Options
An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon price at an agreed-upon date in the future. An option that gives you the right to buy is a call, and one that gives you the right to sell is a put. A call is most valuable if the stock price is going up, whereas a put has more value if the stock price is going down.
Here’s one way to remember the difference: you call up your friend to put down your enemy.
For example, a MSFT 2021 Mar 22.50 call gives you the right to buy Microsoft at $22.50 per share at the expiration date on the third Friday in March 2021. (Did you know that traders refer to Microsoft as “Mr. Softy”? Clever, huh?) If Microsoft is trading above $22.50, you can exercise the option and make a quick profit. If it’s selling below $22.50 you could buy the stock cheaper in the open market, so the option would be worthless.
You can find great information on options, including online tutorials, on the Montreal Exchange’s website, www.m-x.ca. For an American perspective, visit the Chicago Board Options Exchange’s website, www.cboe.com.
Futures
A futures contract gives one the obligation to buy a set quantity of the underlying asset at a set price and a set future date. These started in the agricultural industry because they allowed farmers and food processors to lock in their prices early in the growing season, reducing the amount of uncertainty in their businesses. Futures have now been applied to many different assets, ranging from pork bellies (which really do trade — they are used to make bacon) to currency values. A simple example is a locked-in home mortgage rate; the borrower knows the rate that will be applied before the sale is closed and the loan is finalized. Day traders use futures to trade commodities without having to handle the actual assets.
Most futures contracts are closed out with cash before the settlement date. Financial contracts — futures on currencies, interest rates, or market index values — can only be closed out with cash. Commodity contracts may be settled with the physical items, but almost all are settled with cash. No one hauls a side of beef onto the floor of the Chicago Board of Trade!
Warrants
A warrant is similar to an option, but it’s issued by the company rather than sold on an organized exchange. (After they are issued, warrants trade similarly to stocks.) A warrant gives the holder the right to buy more shares in the company at an agreed-upon price in the future.
A cousin of the warrant is the convertible bond, which is debt issued by the company. The company pays interest on the bond, and the bondholder has the right to exchange it for stock, depending on where interest rates and the stock price are. Convertibles trade on the stock exchanges.
Contract for difference (CFD)
A contract for difference allows traders to get exposure to an underlying asset, such as a share, index, currency, or commodity, without actually owning the asset itself. Because you don’t own the asset commissions are often less — CMC Markets, one of the main CFD brokers, charges $5 for buying a contract on a stock; if you bought the actual stock through a discount broker you’d pay anywhere between $7 and $20.
CFDs are similar to futures contracts, but they have no fixed expiry date or contract size. A trader makes money depending on what the difference is between the initial contract price and the time the CFD is sold.
Buying and selling derivatives
Derivatives trade a little differently than other types of securities because they are based on promises. When someone buys an option on a stock, they aren’t trading the stock with someone right now, they’re buying the right to buy or sell it in the future. That means that the option buyer needs to know that the person on the other side is going to pay up. So, the derivatives exchanges have systems in place to make sure that those who buy and sell the contracts will be able to perform when they have to. Requirements for trading derivatives are different than in other markets.
How derivatives trade
Remember the earlier section on marginability? Well, the word margin is used differently when discussing derivatives, but that’s in part because derivatives are already leveraged — you aren’t buying the asset, just exposure to the price change, so you can get a lot of bang for your buck.
Margin in the derivatives market is the money you have to put up to ensure that you’ll perform on the contract when it comes time to execute it. In the stock market, margin is collateral against a loan from the brokerage firm. In the derivatives markets, margin is collateral against the amount you might have to pay up on the contract. The more likely it is that you will have to pay the party who bought or sold the contract, the more margin money you will have to put up. Some exchanges use the term performance bond instead.
To buy a derivative, you put up the margin with the exchange’s clearing house. That way, the exchange knows you have the money to make good on your side of the deal — if, say, a call option that you sell is executed, or you lose money on a currency forward that you buy. Your brokerage firm will arrange for the deposit.
At the end of each day, derivatives contracts are marked-to-market, meaning that they are revalued. Profits are credited to the trader’s margin account, and losses are deducted. If the margin falls below the necessary amount, the trader will get a call and have to deposit more money.
By definition, day traders close out at the end of every day, so their options are not marked-to-market. The contracts will be someone else’s problem, and the profits or losses on the trade go straight to the margin account, ready for the next day’s trading.
Where derivatives trade
Traditionally, derivative trading involves open-outcry on physical exchanges. Traders on the floor get orders and execute them among themselves, shouting and using hand signals to indicate what they want to do. No central trading post or market maker controls the activities or guarantees a market. Most traders are employees of large commodities brokerage firms, but some are independent. No matter who employs them, traders may be executing someone else’s orders for a fee, or they may be working for proprietary accounts.
Open-outcry has fewer economies of scale than the electronic trading systems that dominate activity in other assets. That’s why there are more derivatives exchanges in the United States than active stock exchanges. Still, all the exchanges offer some electronic trading services, and that has become more and more popular. It’s also causing much restructuring and consolidation among the exchanges. In July 2007, the Chicago Board of Trade merged with the Chicago Mercantile Exchange because floor traders at both exchanges were losing market share to electronic trading.
Sometimes, the people in the pits start messing around with each other, and that can cause unusual volatility in the trading of the securities. Day traders who deal in commodities will often notice short periods of irrational trading for those derivatives that trade primarily in pits. The more human involvement, the less efficient a market will be.
Here are a few places where derivatives trade:
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Montreal Exchange (MX): Most day traders will access American exchanges to trade derivatives, but some instruments can be bought and sold right here in Canada, on the TMX Group’s Montreal Exchange.
The MX is Canada’s oldest exchange, starting up in 1832. In the early 1900s Montreal was Canada’s financial centre; it used to execute many more trades than its Toronto counterpart. The ME was, at one time, so integral to Canada’s financial markets that the terrorist group Front de libération du Québec bombed it in 1969. Over time the exchange began trading options and futures.In 1999 the TSX became the recognized place to sell stocks, and the MX became Canada’s main derivatives exchange. Nine years later the MX merged with the TSX Group to form the TMX Group. These days, the MX’s business is primarily in equity, exchange traded funds, and currency options, and index, interest rate, and energy derivatives.
- Chicago Board of Trade (CBOT): At the top of the Chicago Board of Trade’s building is a statue of Ceres, the Greek goddess of grain. That’s because this is the centre of futures trading in corn, wheat, rice, oats, and soybeans. The Board of Trade has branched out over the years and now offers futures contracts on financial commodities like Treasury bonds and the Dow Jones Industrial Average. Recently, it added trading in ethanol futures, an expansion from its history with corn. When a brokerage firm gets a customer order for a future traded on the Board of Trade it can send it to floor brokers to fill in the trading pits, or it can use the exchange’s electronic trading system.
- Chicago Mercantile Exchange (CME): Futures in non-grain agricultural products, such as milk, butter, cattle, pork bellies, and fertilizer, trade at the Chicago Mercantile Exchange, known more colloquially as “the Merc.” Other key futures traded here include foreign exchange, interest rates, and the Standard & Poor’s and Nasdaq indexes. The Merc has also added some alternative products such as futures in weather and real estate. When brokerage firms receive orders for the Merc’s futures they send them to floor brokers, who can fill them in the trading pits, or they can use the Merc’s electronic trading system.
- New York Mercantile Exchange (NYMEX): Fuels and metals trade at the New York Mercantile Exchange, which is the largest physical commodities exchange in the United States. Most trading takes place in open-outcry pits, but an electronic system is available for overnight trading.
- New York Board of Trade (NYBOT): The New York Board of Trade was founded in 1998, when the Coffee, Sugar, and Cocoa Exchange merged with the New York Cotton Exchange. Here, traders can buy and sell futures and options on those commodities as well as on orange juice, the New York Stock Exchange, the U.S. dollar, and the euro. Orders are filled in the trading pits or through an electronic trading system.
- Chicago Board Options Exchange (CBOE): The Chicago Board Options Exchange, often known by the acronym CBOE (pronounced see-bow), is the largest options market in the United States. This is where orders for stock options are traded. Brokerage firms use floor brokers in the trading pits or the CBOE’s electronic trading system to handle customer orders.