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Feature
 Trading
and Level Playing Fields
by
D.R.
Barton, Jr.
The Little League
World Series is a baseball extravaganza that has captured worldwide
attention for years and is now played before millions via ESPN
broadcasts.
I still
remember the first time I saw a particular young man pitch on TV in
the Little League World Series back in 2001.
His fastball was devastating as he struck out player after
player on the opposing team.
My son Josh
played Little League Baseball for four years, and I served on our
local Little League board, so I know from the inside how far this
organization goes to provide a fair playing environment for the
players. Birth
certificates are required to play and are checked for every player. Additional
scrutiny comes for All Star players to participate in the playoffs
that lead to the World Series. For
four straight Junes, Josh and I dug out original, notarized birth
certificates so that he could play on the All Star team each year.
But for a brief
few weeks in 2001, one pitcher was so dominant that he became the
lead story on ESPN Sports Center—even ahead of the pro players.
He pitched the first perfect game in over 50 years; he struck
out an unheard of 86% of the batters he faced.
And, as it
turned out, he was two years older than every other player on the
field.
An overly zealous little league dad had forged a foreign-born
birth certificate. And
in doing so he created one of the most uneven playing fields in
recent sports history. Everyone who
has kids or has been around children’s athletics knows the huge
difference that two years can make in the 12 year old age bracket.
The young man
(whose name I’ve purposely left out) was a good baseball player
and went on to play baseball at the community college level.
But a good pitcher striking out kids two years
younger is not a level playing field.
Unfortunately,
a similar situation exists in the certain areas of the trading world.
Level
and Not-So-Level Playing Fields
I’m often
asked about what I term the “low capital requirement”
trading instruments. These areas
(e.g., forex, options and futures, and especially the e-mini
futures) have high leverage and the potential to turn a
relatively small account into a much larger one.
Of course, the
hottest of these markets is forex. Thanks to a huge
advertising push, the promises of huge leverage and “no commissions”
(more on that one later), forex market participation has exploded.
Unfortunately,
the retail forex market is not yet a level playing field.
There are some real advantages in
forex; however, none of them overcome the uneven playing field.
To be
fair, I have traded forex through a retail forex broker so that I
could understand the market. I
also believe that there are enough positives about forex that we
should continue to search actively for a way to participate in this
market that provides a fair game for retail traders.
For now, I have not found that venue.
If that’s so, then why is it growing so rapidly?
Let’s look at
forex advantages.
Forex
Advantages
Huge
Underlying Market.
The forex market is underpinned by the interbank currency
market, which facilitates international trade.
So there are massive amounts of transactions made every day
(though most of this is in the major currency pairs).
Extremely
Low Capital Requirements.
Some forex dealers allow you to open an account
with just $200 dollars. I’ve
even seen it as low as $100. Combined
with the huge leverage, there is the
dream of turning a very little pile of cash in to a very big one.
Big
Leverage.
Many forex houses provide 400-to-1 leverage, allowing account
holders to control $400 dollars worth of currency for every $1 in
their account (this leverage ratio typically drops as account sizes
grows).
24-hour
Market.
Forex trades 24 hours a day, five+ days a week.
And there is real action at the Tokyo and London opens.
Trending
Markets.
There are legitimate studies that show currencies among the
most trending financial markets.
Forex
Disadvantages
No Trading
Exchange and Little Regulation.
The real forex market is an interbank dealer market.
Retail accounts are mostly handled by firms that allow
customers to open small accounts and then the firm provides
liquidity or takes the other side of your trade (rather than market
makers and other trading participants).
While this does not ensure abusive practices, it does open
the door.
Trade Fills
as Moving Targets.
I have heard numerous reports about and personally
experienced the posted bid-ask prices being moved, especially in fast
markets. Some
firms may be better at this than others, but the problem appears to
be pervasive.
Higher
Transaction Costs.
While there are no commissions, the forex firms do make the
bid-ask spread and profit from widened spreads during fast markets.
These issues combine to make costs the same or at times
significantly higher than other markets.
The bottom line
is that the retail forex market is still a bit like the Wild West
when compared to other markets.
This uneven playing field means that the edge provided by
your trading strategy has to be even bigger than normal.
Until we’ve
found forex firms that address the
“uneven playing field” issues, we think it is more prudent to
trade currencies on the futures exchanges such as the CME.
Trade
a Market with a Truly Level Playing Field
In futures, e-mini index futures
are quite a
phenomenon. They have
grown unlike any other instrument. E-mini contracts were started by the Chicago Mercantile
Exchange (CME) in 1998 with the S&P 500 e-mini.
As of the first quarter of 2007, the S&P e-mini was
trading 4.5 times the dollar volume of the large S&P 500
contract. Today, the e-mini trades more than 12 to 15 times the
volume of the pit traded contract! There
are many reasons for its popularity.
I’ll share
just a few here:
-
The e-mini
contract is traded electronically on a platform called Globex.
-
Trades are
executed instantaneously and are relatively error-free compared to pit traded contracts that may require several
human interactions before orders are executed.
-
The smaller
size and therefore reduced margin requirements of the e-mini
contracts allow a high degree of retail participation.
The immense
popularity of the S&P e-mini has led to the creation of a number of other equity
indexes trading electronically in the e-mini size.
The most popular of these among traders are the Nasdaq Composites,
Dow Industrial, the up and coming Midcap 400 and the Russell
2000. E-mini trading has
also spread to commodities (e.g., gold, oil), bonds and currencies.
Let’s look at
why traders love these instruments so much.
Leverage.
One of the biggest advantages for e-mini trading is the high
amount of leverage they offer. And
for day traders, brokers increase this leverage further.
Let’s look at the actual leverage available:
the S&P e-mini trade unit is 50 times the S&P 500
Stock Index. Currently,
that calculation is looks like this:
$50 x 1070 = $53,500. The
margin to control $54k worth of underlying stock is around $5.6k,
giving you leverage of about 9.5:1 on your money.
However, the day trading margins are dropped significantly
with $1,000 margins still available and some reputable firms
offering $500 margins. At
these rates, you can increase your intraday margin to greater than
100:1!
But leverage is
a double-edged sword that definitely cuts both ways.
While such leverage allows for large returns on very little
money, it also means that you could lose large amounts.
In next week’s article, we’ll cover tools that allow us
to use this leverage in a big way, even while protecting our downside.
Liquidity.
Liquidity is usually thought of in terms of volume. It is
the characteristic that gives us the ability to get in/out of trades
both quickly and at a preferable price.
E-mini index trading gives us exceptional liquidity and great
fills with little slippage. These
attributes allow us to take full advantage of the available
leverage.
Scalability.
There are certain types of trading that can only be used on a
small scale and cannot be translated to larger volumes as larger
position sizes are required. But
e-mini index trading in general and S&P e-mini trading in
particular are highly scalable.
Getting virtually no-slippage fills on 200 S&P e-mini
contracts is an extreme advantage to large scale traders.
Round-the-clock
liquidity.
The S&P e-mini has liquidity 23.5 hours a day, which
gives another advantage—the effect of overnight gaps is greatly
reduced. You can keep a
stop in the market if you’re doing a swing trade and have your
protection kick in at a time when your IBM stock is still sleeping.
The
Best Market Keeps Getting Better
As I mentioned
above, higher volatility equates to greater opportunity for day
traders. Today’s
markets, while not having the volatility of last fall or this past
spring, still have good volatility.
However, with moderate volatility, it is really important to
be patient and wait for the 2 to 5 high quality set-ups that come
almost every day.
Please note
that I’ll be teaching our highly rated, cutting edge workshop on
e-mini index trading in Cary, N.C., on November 7 – 9.
It’s a learning experience you don’t want to miss!
Next week
we’ll look at some specific tools and strategies that top e-mini
traders are using today to take profits in these markets,
and I’ll tell you about my good friend and market
maven who will be joining us for the workshop.
About
D.R. Barton, Jr.: A passion
for the systematic approach to the markets and lifelong love of
teaching and learning have propelled D.R. Barton, Jr. to the top
of the investment and trading arena. He is a regularly
featured guest on both Report
on Business TV, and
WTOP News Radio in Washington, D.C., and has been a guest on
Bloomberg Radio. His
articles have appeared on SmartMoney.com and Financial
Advisor magazine. You may contact D.R. at
"drbarton" at "iitm.com".
Disclaimer
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