5 mistakes of day traders

There are certain mistakes that day traders make that, if made regularly, are likely to empty his account. Traders often use strategies to try and exaggerate their returns, but the following methods often result in lower returns, or even losses.

1. Averaging down

Averaging down is when a trader adds to a losing trade to bring down the average value of the units in his position. 

If we use share trading as an example, a trader might have 1000 Qantas shares he bought at AUD2.80. When they dropped to AUD1.50, he bought another 1000. This makes the total cost of his position ADU4,300 ([AUD2.80 x 1000 shares] + [AUD1.50 x 1000 shares] = AUD4,300), and the average value of each share AUD2.15. This means that the share price no longer needs to rise above AUD2.80 for him to make a profit, it only needs to rise to AUD2.15.

If the share price then falls to AUD1.00 he might buy another 1000 shares, bringing the total cost of his position to AUD5,300 and the value of each share AUD1.77. The shares will have to rise by 77 cents for the trader to break even, and more for him to make a profit. Although this is possible, there is no telling when the market might turn to that degree, and the trader is more likely to make a loss than a profit.

When it comes to instruments traded on a margin, such as CFDs on shares or forex, a trader can access a wide position for a relatively small deposit. Although this can magnify the return on his initial investment, it will magnify his losses to the same degree.

If you were to trade Qantas share CFDs rather than Qantas shares, you could open a position with a deposit that is only a fraction of the value of the position. For this example, we’ll assume a margin requirement of 5%, meaning that your initial position on 1000 shares valued at AUD2.80 could be opened with a deposit of AUD140 (AUD2.80 x 1000 x 5% = AUD140).

When the shares dropped to AUD1.50, you could open a position on another 1000 shares with a deposit of AUD75. When the shares dropped again to AUD1.00, you could open another position on another 1000 shares for AUD50.

You have paid a total of AUD265 for your positions on 3000 Qantas shares. As the share price has dropped to AUD1.00 per share, the total value of your positions is AUD3,000. The average value of each share based on their initial prices is the same as it was when you were trading conventional shares: AUD1.77.

If the share price rises to AUD2, you could close your positions on 3000 shares for AUD6,000, whether you were trading shares or share CFDs (excluding commissions, financing charges and dividends). To buy 3000 shares you needed to pay a total of AUD5,300, leaving you with a profit of AUD700.

However, when trading CFDs you only made a deposit on AUD265, leaving you with a profit of AUD5,735. 

This example reveals why it is so tempting to average down with geared products like CFDs; if you are depositing so little, why not?

Because you can lose just as much as you can gain.

If the share price had dropped again to AUD0.95 you may have decided to take the loss. The 3000 shares would now be worth AUD2,850. In conventional share trading you would have lost AUD2,450, or 46% of your investment of AUD5,300.

You would have lost the same amount when trading CFDs. As share CFDs mirror every aspect of share trading, the opening value of each position was the same as the opening value of every thousand Qantas shares you would have purchased conventionally. The first thousand were worth AUD2,800, the second thousand were worth AUD1,500 and the third thousand were worth AUD1,000. This means you also lost AUD2,450. However, where that was 46% of your investment in shares, it is now 924.5% of your AUD265 investment in CFDs.

Although some traders might be tempted to keep averaging down until the market turns, this is not advisable. When, or even whether, the market will turn is never certain, and sustaining such a great loss in respect to your initial investment can leave you subject to a margin call.

Prepositioning for news

News events can often have a large impact on the market, and traders can make great profits if they use this in their trading.

However, more often than not, the direction in which the market will move is not known in advance. 

Something quite simple, like an interest rate announcement, might be expected to appreciate or depreciate a forex pair, but the trader cannot know what additional statements, figures or forecasts will accompany it.

Frequently volatility surges following a large announcement, and it is difficult to determine a trend in the market, or even if the announcement resulted in a trend following the initial volatility. For these reasons, taking a single position before a news announcement can jeopardise a trader’s chance of success.

One strategy for trading an upcoming announcement is using a spread, which may reap profits as long as the market moves, even if you don’t know the direction it will take.

Trading right after news

Although there are some trading strategies that may be successful following reports and economic announcements, trading announcements without a system can be just as risk as placing a trade before a release.

News announcements can result in large volumes of trades in both directions, meaning that many traders will make losses as it swings back and forth. Entering a trade like this without any risk management, such as using stops and limit orders can result in you losing more than you wanted to risk. In fact, entering a trade like this with stop and limit orders can result in your stops being triggered over and over as the market swings back and forth.

Day traders wanting to trade economic announcements should watch the market after the announcement has been made, and take a position after the initial volatility has subsided.

Risking too much

As seen when discussing averaging down, risking large amounts does not equate to proportionate returns. All traders lose at some point, and those who risk large amounts of capital on single trades will be hit harder than most as they will lose a larger percentage of their account.

A common rule of thumb is that a trade should risk no more than 2% of his capital on a single trade, though some traders set lower limits.

It is also a good idea to set limits on the amount you are willing to risk over a certain period. In day trading, it is a good idea not to risk more than 1-2% a day. So, if you made four trades a day with a 1% limit on your risk for the day, each trade would risk 0.25% of your account. 

The amount you are willing to risk will depend on your profit targets, your level of capital, and whether you are trading intra-day or over a few weeks or months. Just keep in mind the amount you are willing to lose, rather than potential profits that may not eventuate.

Unrealistic expectations

Unrealistic expectations are usually the foundation of the previous four mistakes:

1.       The trader who unrealistically expects the down-trending stock to turn around and win back his losses

2.       The trader who thinks he can predict the market reaction to news and make large profits (admittedly it has been done, but is very risky)

3.       The trader who immediately trades after an announcement, expecting to make a larger profit by jumping into the trade sooner

4.       Expecting eventual profits to offset high levels of risk

Unfortunately the market doesn’t take our expectations into consideration. It is largely driven by people, who are also illogical, so being able to profit on every single move is not possible and will result in errors of judgement.

Conclusion

The best way to avoid these mistakes is to create a trading system and then stick to it. Your trading system should cover your criteria for entering and exiting trades as well as the amount you are willing to risk and profit targets, which will assist you in placing trades as well as stop losses and limit orders. If it yields consistent profits, don’t change it.

Using a combination of fundamental and technical analysis can help you plan trades and evaluate possible market reactions to events, but if the signals you are using don’t back up what you think will happen, then it is safer to follow them and stay out of the trade. Likewise, if your stop is about to be hit, don’t move it in the hope that the market will turn! The hardest part of using a trading system is following its rules in all situations; but doing it will reward you with more consistent profits over time.

Using mergers and acquisitions in forex trading

The relationship between the stock and forex markets

The stock market can impact the forex market in a number of ways. For instance, if a strong stock market rally  happens in the UK, with the FTSE 100 and FTSE AIM All-Share making large moves, this is likely to result in a flow of foreign capital into the UK as international investors want to profit on the trend. As a result, the British pound would rise as foreign investors would have to purchase GBP in order to participate in the British markets, increasing demand for the currency.

The opposite is also true – if the UK stock market falls, foreign investors will choose a better-performing market, selling their pounds to invest in another currency, resulting in the GBP falling in value as supply overtakes demand.

Taking this one step further, we can infer that mergers and acquisitions (M&As) which boost the stock market are likely to boost the local currency. Professional currency traders will usually focus on cross-border M&As worth over USD1 billion. As cross-border transactions will result in the acquiring company having to pay the price for the target company in the target company’s currency (in the case of a merger, a deal in which one of the currencies is converted is also likely to take place).

Large M&A deals cause the domestic currency of the target company to appreciate relative to the acquirer’s currency, according to a study conducted by Francis Breedon and Francesca Fornasari of Lehman Brothers in 2000. They found that for every USD1 billion deal, the target company’s currency would increase by 0.5%, and would be 1% stronger fifty days after the announcement. However, the study found that the currency impact tends to peak around 5%.

So if an American company took-over an Australian company, the AUD/USD pair would quickly rise by 0.5%, registering a 1% gain at the fifty day mark.

Determining the impact

Each deal can have a different impact on the forex market, and one way to predict the potential size of the impact is to check how the deal is structured. An all-cash deal will have a much more significant impact on the forex market than an all-stock deal.

An all-cash deal would result in a large transaction and, consequently, a large demand for the target company’s currency, whereas an all-stock deal would result in smaller currency movements over time as foreign shareholders buy and sell the shares. An all-stock deal could also result in a diverse geographical distribution of shareholders, resulting in international investors repatriating their dividend payments, which may also impact the currency value.

The impact of a deal that is a combination of stock and cash will depend on the proportion of the deal that is cash – the higher the cash proportion, the larger the impact on the forex market.

Trading forex with mergers and acquisitions

Although numerous factors impact different currency pairs, the announcement of a large M&A deal can have a meaningful impact on a pair’s price.

On February 9, the Deutsche Bourse confirmed a takeover deal with the NYSE. The deal was valued at USD10 billion and, to make the takeover, the Deutsche Bourse would need to convert Euros into US dollars, thus creating a higher demand for US dollars.

On February 9, the EUR/USD forex pair rose from its opening price of 1.36251 to a high of 1.37440, a jump of 118.9 pips in one day. Over the next fifty days, the pair reached a high of 1.42484 on March 22, falling to 1.4174 on March 30, or day fifty. This is a total increase of 522 pips, or a gross profit of USD5,220.

EUR/USD February to April 2011. Source - Onada

The following chart shows the AUD/CAD from August to November 2010. On the weekend of August 14, Canadian firm Agrium Inc made an unsolicited bid for Australian grain seller AWB Ltd of AUD1.2 billion. 

Although there wasn’t much movement in the currency pair that weekend, on Monday the 16^th the pair rose from an opening price of 0.93089 to a high of 0.93905, a rise of 81 pips. Over the next fifty days, the pair rose to 0.99276. It continued to rise to 1.00536 before the pair grew more volatile in November through to March, though this subsequent rise was probably unrelated to the takeover bid.

AUD/CAD August to November 2010. Source - Onada

Although numerous factors affect the forex market, take large, cross-border mergers and acquisitions into consideration when you trade can help you identify trading opportunities that others might miss.

Use GDP in your forex trading

Economic releases are essential for the fundamental trader, and can also help the technical trader when judging how long a trend is likely to last.

Gross domestic product, or GDP, is one of the most important releases, covering an economy’s consumption, investment, government spending and investment, and exports. The sum of these numbers is the GDP. 

As GDP takes a number of macroeconomic factors into consideration, it serves as evidence of growth in a productive economy, or shrinkage in a weakening one. Consequently, forex traders often go long on the currencies of countries with higher GDPs in the belief that interest rates will also rise. If an economy is growing, the benefits should trickle down to the consumer who will be more likely to spend, resulting in higher prices and higher interest rates as central banks try to ward off inflation.

Expectations and their affect on the forex market

GDP figures are released in three versions, advanced, preliminary and final. Currency professionals will use the advanced version when trading; however, they will then compare this with the preliminary and final ones as they are released. There are three possibilities when the final version is released – the GDP figure will be higher than expected, lower than expected or as expected.

If the advanced release predicted GDP growth of 1.5% and the final release announced 4% GDP growth, the underlying currency is likely to strengthen in relation to other currencies, as forex traders think it is a better investment. Typically, the higher the GDP figure, the sharper the currency’s incline.

An expected figure generally requires some more comparison. A trader should compare the current figure to that of the previous quarter or the previous year to evaluate the situation. If GDP growth is positive, but not as high as the previous quarter, this is likely to be negative for the currency. Likewise, if GDP growth is higher than the previous quarter or year, traders are likely to invest.

On the other hand, if an advanced release predicts 3.5% GDP growth and the final version only states 2% GDP growth, that economy’s currency is likely to drop as traders sell-off, following the lower reading. A lower GDP figure would warn of an economic contraction and lower interest rates, lowering the value of assets denominated in that currency.

Example

UK GDP for the second quarter in 2011 only increased by 0.2%, following a 0.5% increase in the first quarter. Although special events associated with the quarter, such as the royal wedding and the Japanese tsunami, may have had an impact, growth was lower than expected.

If we look at the GBP/EUR chart approaching the July 26 preliminary GDP release, the pound hits a two-week low against the euro ahead of economic data. The figures, released at 8:30am, were expected to show faltering economic recovery, with GDP growing just 0.2% in the second quarter. The release did, in fact, release the expected figures.

As the figures were to be expected, and the eurozone also hasn’t been performing well recently, this could be a good opportunity to go long. This is backed up by the chart over the following days – having hit a low of 1.2566 against the euro, the forex pair started to climb following the expected release, trading within the 1.138 and 1.144 range until the August 1 US debt ceiling announcement. 

 GBP/EUR

If the release had been worse than expected, the pair may have tested its early-July low of 1.10089. And, if the release had been better, traders could expect a steeper rise, though there would always have been further volatility surrounding the US debt ceiling agreement.

Conclusion

The GDP reports of any major currency will always be an important fundamental to consider when it comes to trading forex. Releases that vary from expectations can be great opportunities for traders to cash in on large currency movements.

Seasonal patterns in stock indices

As stock indices are a compilation of a group of companies, often the leading companies in a particular economy, they can be representative of economies at large. As such, indices can move in seasonal patterns, moving with regular economic announcements.

Obviously politics, company announcements and once-off economic releases can impact this and obscure broader patterns in the market, however, these patterns do tend to persist year-on-year. And, like any pattern, this is something of which the astute trader can take advantage.

Once example was illustrated in the book ‘The Behaviour of Prices on Wall Street’ by Art Merrill, which demonstrated the existence of preholiday behaviour in the Dow Jones, concluding that there was a high probability of the index having higher closing prices before major US holidays.

Another example is the S&P 500 index – from 1980 to today, the market has usually rallied from late January until early June. From June until late August the market tends to trade sideways, before falling from late August until late October. From late October the market has a steeper climb until the end of the year.

However, these patterns may not occur every year – in February 2009 the S&P 500 index fell dramatically, even though the seasonal bias indicated that the market should be climbing higher.

Hedging using Index CFDs

Stock index CFDs provide a useful way to hedge existing stock positions in volatile markets – as CFDs can be traded long or short traders are able to open a short position on an index that is representative of their stock portfolio, knowing that any losses in their stock portfolio will be offset by their index CFD position.

For example, an investor might hold a balanced stock portfolio valued at $100,000. For simplicity’s sake, let’s assume the portfolio consists of stock from 20 Australian companies, each position he holds is of 1,000 shares, and the average value of each share is $5 (20 companies x 1,000 shares = 20,000 shares x $5 per share = $100,000 portfolio value).

He is worried about short-term volatility and his assets falling in value, but doesn’t want to sell his positions as he expects the market to trend up over the long-term.

Instead, he decides to offset possible losses by opening a short position on the Australia 200 Index – as an index is a statistical measure of the value of a group of stock, it will rise and fall with the changing value of individual shares. Again for simplicity’s sake, we’ll assume that a ten point movement the Australia 200 moves corresponds with a $1 movement in his stock (or a $20,000 movement across his portfolio).

A CFD position on the Australia 200 costs or pays $25 per index point movement per contract. As he is trading short, he would have to sell 80 contracts to hedge his current portfolio:

10 point Australia 200 movement = $20,000 portfolio movement

1 point Australia 200 movement = $25 payment/loss from the index position

Therefore $20,000/$25/10 = 80 Australia 200 contracts required to hedge the position

He sells, or goes short on, 80 contracts, knowing that now his share position is hedged if the market fluctuates. For every dollar he loses on his stock portfolio, he will gain a dollar on his Australia 200 position. Likewise, for every dollar he loses on his index position, he will gain a dollar on his stock portfolio.

From here there are three possible scenarios – the stock and index go up in value, the stock and index go down in value, or the stock and index trade sideways.

The stock and index go up in value

The market continues trending upwards, and his portfolio is soon worth $110,000. However, as the trader had sold the Australia 200 with the hope that it would fall, he has made a $10,000 loss on that position. If he believes the market will continue to go up, he could close his Australia 200 position and continue to enjoy to profits of his stock portfolio. If he still thinks there are volatile times ahead, he could keep that position open, knowing that any possible losses will be offset by his stock portfolio.

The stock and index fall in value

If the trader loses $2 per share, or $40,000 across his portfolio, he will make a $40,000 profit on his index CFD position, which would cancel out those losses. Once he believes the price has bottom out, he could close the index position, taking those profits and holding onto the stock until its price rises again.

The stock and index remain flat

The investor will not have made a profit or loss on either trade.

Index CFDs are a useful tool for protecting existing investments against price fluctuations. That being said, this strategy is a market-neutral strategy, meaning that although you will not make a loss, you will not make a profit either for as long as both positions are open. Hedging can lower profit potential, but as it also limits losses, it can reward traders with a steadier flow of profit over time.

Options styles

Different styles of options include European options, American options, Bermudan options, Barrier options, Exotic options and Vanilla options (a vanilla option being any option that is not exotic).

American and European options

European options are options that may only be exercised on their expiration date, while American options can be exercised on or before that date. American options expire on the third Saturday of every month and are closed for trading the Friday before, while European options expire the third Friday of every month and are closed for trading on the Thursday before.

For both styles of options, the pay-off is calculated as:

The maximum of the strike price minus the spot price or zero, for a call option

The maximum of the spot price minus strike price or zero, for a put option

Where an American and European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European option. If it is worth more, the difference in value can be used to determine whether or not it should be exercised before the expiration date.

Options contracts traded on exchanges are mainly American, whereas options traded over the counter are mainly European.

Bermudan options

A Bermudan option is an option that may be exercised on specific dates on or before expiration. This option is half-way between European (which allow exercise at one time) and American (which allow exercise at any time) options. Most exotic interest rate options are Bermudan style options.

Barrier options

Barrier options can only be exercised once the underlying asset’s price has passed a certain level, or barrier. Barrier options are always cheaper than non-barrier options, and were created to allow investors to hedge with options without having to pay as high a premium.

The two types of barrier options are ‘in’ options and ‘out’ options – in options start their lives worthless and become active when a set barrier is reached, while out options start their lives active and become worthless once a barrier is broken. Both in and out options can be divided into two more categories – up-and-out or down-and-out, or up-and-in and down-and-in.

• Up-and-out: the spot price starts below the barrier and has to rise for the option to expire
• Down-and-out: the spot price starts above the barrier level and has to fall for the option to expire
• Up-and-in: the spot price starts below the barrier level and has to rise for the option to become activated
• Down-and-in: the spot price starts above the barrier level and has to fall for the option to become activated

Exotic options

Exotic options can have both standard and non-standard exercise styles, as well as standard and non-standard pay-off calculations.

Exotic options with standard exercise styles can be exercised either in the European or American style, the only difference being the calculation of their pay-off value:

• A cross option is an option on an asset in one currency with a strike price denominated in another currency – one example would be IBM, which is denominated in US dollars. Trading on IBM in Japan would involve converting the pay-off into Japanese Yen, meaning the pricing of these options needs to take forex volatility into account. A quanto option is another version of this, but the exchange rate is set from the outset of the trade.
• An exchange option is the right to exchange one asset for another.
• A basket option is an option on the weighted average of several underlying assets. A rainbow option is a basket option where the weighting depends on the financial performance of each asset.
• A low exercise price option is a European call option with a low exercise price of USD0.01.

Some exotic options can use the same pay-off values as American and European options, but the early exercise can occur differently:

• A Canary option is an option with exercise styles between European options and Bermudan options – typically the holder can exercise the option at quarterly dates, but not before a set time period (usually 12 months) has passed.
• A capped-style option is a conventional option with a profit cap written into the contract – capped-style options are automatically exercised when the underlying asset reaches that price.
• A compound option is an option on an option, giving the holder two separate exercise dates and decisions.
• A shout option allows the holder two exercise dates – during the life of the option the holder can ‘shout’ to the seller that they want to lock-in the current price, and if this gives them a better deal than the ay-off at maturity they can use the shout date price rather than the price at maturity to calculate the pay-off.
• A swing option gives the holder the right to exercise only one call or put on any one of a number of specified exercise dates, with penalties imposed with the holder has a net volume higher or lower than specified upper or lower limits.

Other exotic options have pay-offs that are calculated quite differently, alongside their exercise styles varying:

• A look-back option is an option where the holder has the right to buy or sell an underlying asset at its lowest or highest price over a preceding period. A Russian option is a type of look-back option that has an infinite preceding period.
• An Asian (or average) option’s payoff is determined by the average price of the underlying asset over a predetermined period of time.
• A game (or Israeli) option is an option where the writer can cancel the option offered, but must pay that point’s pay-off as well as a penalty fee.
• A cumulative Parisian option has a pay-off dependent on the total amount of time the underlying asset value is above or below a certain strike price, while a standard Parisian option is dependent on the maximum amount of time the underlying asset value spent consecutively above or below a strike price.
• A re-option occurs when a contract has expired without having been exercised, and the owner of the underlying asset may then re-option the asset.
• A binary (or digital) option pays a fixed amount, or nothing at all, depending on the price of the underlying asset at maturity.
• A forward start option is an option with a strike price to be determined in the future, and a cliquet option is a sequence of forward start options.

What is a market bubble?

A bubble is when an economy, market or asset has a large price spike, exceeding what is considered to be its fundamental value by a large margin. Bubbles are usually identified in hindsight, generally after there has been a crash of the price of the economy, market or asset in question.

The damage caused by the burst of the bubble depends on the economic sector or sectors involved – the bursting of the US housing bubble in 2008 caused a global financial crisis, because most banks and financial institutions in the US and Europe held billions of dollars worth of subprime mortgage-backed securities.

The five steps of a bubble

Economist Hyman P Minsky identified five stages in a credit cycle – displacement, boom, euphoria, profit taking and panic – and this general pattern is fairly consistent across bubbles in varying sectors.

Stage 1 – Displacement

Displacement occurs when investors become infatuated with something new – new technology in the dot-com bubble, tulips in tulip mania (a bubble in the 17^th century where the popularity of tulips shot up so quickly that tulips started selling for over ten times the annual income of skilled craftsmen. Within months of the bubble bursting, tulips were selling for 1/100^th of their peak prices), or historically low interest rates, as in the US in June 2003, which started the build-up to the housing bubble.

Stage 2 – Boom

Following a displacement, prices begin to rise slowly. They gain momentum as more participants enter the market, causing the asset to attract widespread media coverage, then panic buying, which forces prices to record highs.

Stage 3 – Euphoria

Prices skyrocket – in the 1989 real estate bubble in Japan, land in Tokyo sold for up to USD139,000 per square foot. At the height of the internet bubble in March 2000, the combined value of the technology stocks on the NASDAQ was greater than the GDP of most nations.

During the euphoric phase, new valuation measures are promoted to justify the jump in prices.

Stage 4 – Profit taking

By this time, skilled traders start selling their positions and taking profits – sensing that the bubble is going to burst. However, determining the moment of collapse can be very difficult and, if you miss it, you have likely missed your chance to take profits for good.

Stage 5 – Panic

At this point, prices fall as quickly as they originally rose. Traders faced with margin calls and the falling values of their assets start panic selling – getting out of their investments at any cost. Supply soon overwhelms demand, and prices plummet.

In the 1989 Japanese real estate bubble, real estate lost nearly 80% of its inflated value, while stock prices fell by 70%. Similarly, in October 2008, following the collapse of Lehman Brothers, and the almost-collapse of Fannie Mae, Freddie Mac and AIG, the S&P 500 plunged almost 17% in that month. That month, global equity markets lost USD9.3 trillion, or 22% for their combined market capitalisation.

Conclusion

Being familiar with the steps of a bubble, whether it’s in the stock, forex, commodities or bonds market, may help you identify the next one, and get out before your profits vanish.