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Introduction
The Stock Market
The stock market is where shares of stock are traded. A share of stock is an ownership share in a corporation. For example, assume XYZ Inc. has issued 100 shares of stock. If you own one share, you actually own a 1.0% stake in XYZ Inc. Shares of stock issued by large U.S. corporations are publicly traded at stock markets or stock exchanges. The prices of these shares are constantly changing as they are determined solely by supply and demand. Anyone with money can buy shares in these corporations by simply setting up an account with a stock broker and submitting a purchase order. The order is electronically transferred to the stock exchange, where the order is executed.
Stock Market Indexes
A stock market index is a number computed from the prices of a group of stocks. It is computed daily to gauge the movement in the market for that day. Here are some examples:
Dow Jones Industrial Average (DJIA)
The DJIA is computed by adding all the daily stock prices of a group of 30 major U.S. corporations and dividing that total by a number called the divisor; this is called a price-weighed method. This divisor will change whenever one of the 30 companies declares a stock split. A company will split its stock when the price becomes high, making it more affordable. By changing the divisor, the index value is unaffected by stock splits.
S&P 500 Index
The S&P 500 doesn't have the disadvantages of the DJIA. It is made up of 500 stocks. The total market value of each company is computed and summed. A company's market value is simply the share price times the total shares outstanding. The sum of all 500 companies' market values is then divided by a divisor. The result is that each company influences the index based on its total market value rather than its share price. This type of index is a capitalization-based index.
Stock Mutual Funds
A stock mutual fund is a portfolio of stocks that has been purchased by a fund manager using money that has been invested by many individual investors. At the end of each trading day, the total value of the portfolio is determined and divided by the total number of outstanding shares, resulting in the current share price. All new investments the fund has received prior to that market close (4:00 p.m. EST) are exchanged for shares in the fund using the share price. The fund manager then invests the new investment capital.
Stock Market Movement
Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward.
Positions
Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash.
Long Positions
If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position.
Short Positions
If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details.
Mutual funds can be shorted through most discount brokers but it really doesn't make much sense. In a bear market the wise short seller will short stocks that are likely to go down the most. But, during a bear market the mutual fund will hold stocks that they think are likely to go down the least. So, it doesn't make much sense to short a group of stocks that a professional stock picker believes will be least effected by the bear market.
Cash Positions
If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position.
Buying On Margin
If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital.
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Why Most Futures Traders Lose Money
A review of 50 very basic, often violated rules for trading futures
A survey of more than 500 experienced futures brokers asked what, in their experience, caused most futures traders to lose money. These account executives represent the trading experience of more than 10,000 futures traders. In addition, most of these Account Executives (AEs) have also traded or are cur rently trading for themselves. Their answers are not summarized because different traders make (and lose) money for different reasons. Perhaps you may recognize some of your strengths and weaknesses. Yet many of the reasons given are very similar from broker to broker. The repetitions stand to demonstrate that alas, many futures traders lose money for many of the same reasons. Perhaps these statements from experienced brokers can make a contribution to you, and make this sometimes fickle, often intricate, always interesting market place of futures trading possible.
Here is what they said:
1. Many futures traders trade without a plan. They do not define specific risk and profit objectives before trading. Even if they establish a plan, they “second guess” it and don’t stick to it, particularly if the trade is a loss. Consequently, they overtrade and use their equity to the limit (are undercapitalized), which puts them in a squeeze and forces them to liquidate positions.
Usually, they liquidate the good trades and keep the bad ones.
2. Many traders don’t realize the news they hear and read has, in many cases, already been discounted by the market.
3. After several profitable trades, many speculators become wild and unconservative. They base their trades on hunches and long shots, rather than sound fundamental and technical reasoning, or put their money into one deal that “can’t fail.”
4. Traders often try to carry too big a position with too little capital, and trade too frequently for the size of the account.
5. Some traders try to “beat the market” by day trad-ing, nervous scalping, and getting greedy.
6. They fail to pre-define risk, add to a losing position, and fail to use stops.
7 .They frequently have a directional bias; for example, always wanting to be long.
8. Lack of experience in the market causes many traders to become emotionally and/or financially committed to one trade, and unwilling or unable to take a loss. They may be unable to admit they have made a mistake, or they look at the market on too short a timeframe.
9. They overtrade.
10. Many traders can’t (or don’t) take the small losses. They often stick with a loser until it really hurts, then take the loss. This is an undisciplined approach...a trader needs to develop and stick with a system.
11. Many traders get a fundamental case and hang onto it, even after the market technically turns. Only believe fundamentals as long as the technical signals follow. Both must agree.
12. Many traders break a cardinal rule: “Cut losses short. Let profits run.”
13. Many people trade with their hearts instead of their heads. For some traders, adversity (or success) distorts judgment. That’s why they should have a plan first, and stick to it.
14. Often traders have bad timing, and not enough capital to survive the shake out.
15. Too many traders perceive futures markets as an intuitive arena. The inability to distinguish between price fluctuations which reflect a fundamental change and those which represent an interim change often causes losses.
16. Not following a disciplined trading program leads to accepting large losses and small profits. Many traders do not define offensive and defensive plans when an initial position is taken.
17. Emotion makes many traders hold a loser too long. Many traders don’t discipline themselves to take small losses and big gains.
18. Too many traders are underfinanced, and get washed out at the extremes.
19. Greed causes some traders to allow profits to dwindle into losses while hoping for larger profits.
This is really a lack of discipline. Also, having too many trades on at one time and overtrading for the amount of capital involved can stem from greed.
20. Trying to trade inactive markets is dangerous.
21. Taking too big a risk with too little profit potential is a sure road to losses.
22. Many traders lose by not taking losses in proportion to the size of their accounts.
23. Often, traders do not recognize the difference between trading markets and trending markets.
Lack of discipline is a major shortcoming.
24. Lack of discipline includes several lesser items; i.e., impatience, need for action, etc. Also, many traders are unable to take a loss and do it quickly.
25. Trading against the trend, especially without reasonable stops, and insufficient capital to trade with and/or improper money management are major causes of large tosses in the futures markets; however, a large capital base alone does not guarantee success.
26. Overtrading is dangerous, and often stems from lack of planning.
27. Trading very speculative commodities is a frequent mistake.
28. There is a striking inability to stay with winners. Most traders are too willing to take small profits and, therefore, miss out on big profits. Another problem is undercapitalization; small accounts can’t diversify, and can’t use valid stops.
29. Some traders are on an ego trip and won’t take advice from another person; any trades must be their ideas.
30. Many traders have the habit of not cutting losses fast, and getting out of winners too soon. It sounds simple, but it takes discipline to trade correctly. This is hard whether you’re losing or winning.
Many traders overtrade their accounts.
31. Futures traders tend to have no discipline, no plan, and no patience. They overtrade and can’t wait for the right opportunity. Instead, they seem compelled to trade every rumor.
32. Staying with a losing positien because a trader’s information (or worse yet, intuition) indicates the deteriorating market is only a temporary situation can lead to large losses.
33. Lack of risk capital in the market means inadequate capital for diversification and staying power in the market.
34. Some speculators don’t have the temperament to accept small losses in a trade, or the patience to let winners ride.
35. Greed, as evidenced by trying to pick tops or bottoms, is a frequent error.
36. Not having a trading plan results in a lack of money management. Then, when too much ego gets involved, the result is emotional trading.
37. Frequently, traders judge markets on the local situation only, rather than taking the worldwide situation into account.
38. Speculators allow emotions to overcome intelligence when markets are going for them or against them. They do not have a plan and follow it. A good plan must include defense points (stops).
39. Some traders are not willing to believe price action, and thus trade contrary to the trend.
40. Many speculators trade only one commodity.
41. Getting out of a rallying commodity too quickly, or holding losers too long results in losses.
42. Trading against the trend is a common mistake. This may result from overtrading, too many day trades, and undercapitalization, accentuated by failure to use a money management approach to trading futures.
43. Often, traders jump into a market based on a story in the morning paper; the market many times has already discounted the information.
44. Lack of self-discipline on the part of the trader and/ or broker creates losses.
Futures traders tend to do inadequate research.
45. Traders don’t clearly identify and then adhere to risk parameters; i.e., stops.
46. Most traders overtrade without doing enough research. They take too many positions with too little information. They do a lot of day trading for which they are undermargined; thus, they are unable to accept small losses.
47. Many speculators use “conventional wisdom” which is either local, or “old news” to the market. They take small profits, not riding gains as they should, and tend to stay with losing positions. Most traders do not spend enough time and effort analyzing the market, and/or analyzing their own emotional make ups.
48. Too many traders do not apply money management techniques. They have no discipline, no plan. Many also overstay when the market goes against them, and won’t limit their losse
49 Many traders are undercapitalized. They trade positions too large, relative to their available capital. They are not flexible enough to change their minds or opinions when the trend is clearly against their positions. They don’t have a good battle plan and the courage to stick to it.
50. Don’t make trading decisions based on inside information. It’s illegal, and besides, it’s usually wrong.
DESPITE THE STATEMENTS ABOVE, IT SHOULD BE NOTED THAT THERE IS A RISK OF LOSS IN ALL COMMODITY INVESTMENTS WHICH ARE HIGHLY SPECULATIVE IN NATURE. ONLY RISK CAPITAL SHOULD BE USED FOR SUCH INVESTMENTS.
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