Which way to trade?

Fact: We all have a view on the market
Reality: It's not always the right one!

Fact: Sometimes our view is correct
Reality: We don't always make money!

Frustrating I know, but we need to find the right product to trade; and more importantly the right style.

You can imagine the rollercoaster ride than many traders experienced during the volatile markets of the last fifteen months. You only have to look at the daily ranges that indices like the FTSE 100 had in the autumn of last year to appreciate that white knuckle rides are not even the preferred environment of the most savvy of traders.

I remember last October and November, and I am sure you do too, knowing that when the market closed in the afternoon at 4.30pm, it was likely to open either a few hundred points higher or a few hundred points lower, purely dependent on the direction of Wall Street from 4.30pm to 9.15pm.
How can we predict or more importantly make money out of holding a position in a market, which we cannot trade and know is going to ‘gap' up or down by a huge amount the following morning. Sounds like a massive gamble to me.

Actually we don't need to hold onto positions forever in the vain hope that we will make a fortune at some point in the future.
So what's the alternative: a relatively low risk, controlled strategy of buying and selling within very short timescales, taking tiny margins of profit...buts lots of them? Welcome to the world of day-trading

A simple definition: Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions will usually, but not always, be closed before the market close of the trading day.

So who are today's day traders? Well, pre-tech boom (& bust), day traders were predominantly self financed ex-bank and futures floor traders, who stood shoulder to shoulder in the open outcry pits of the International Futures Exchanges, shouting and screaming while signalling to each other the prices at which they wished to trade. Mayhem it must sound, but actually there existed a very efficient market place for trading the financial markets. Some of these self- financed traders, otherwise known as locals, would wander down onto the floor, sometimes straight out of school, hungry to make their fortune... ‘Trading Places' style.

In the late 90s, technology soon won the exchanges over and these thriving day traders migrated to newly set up ‘Trading Arcades'; providing them with a professional dealing environment, allowing them to compete with their banking and corporate peers. And these arcades initially accommodated hundreds of ex floor traders who provided important liquidity to the worlds futures markets.

And then the millennium saw a 3 year bear market that took the FTSE 100 from 6950 to 3380, a whopping 51% decline, well within the definition of a bear market (20% decline!) This down move made many active retail investors, who to that date were nearly always ‘long only' merchants, look for instruments and strategies that would allow them to capitalise on falling markets as opposed to good old bull markets. So the search led them to the derivatives markets, including Futures, CFDs and Spread Betting.

Speculating on intra day moves may mean one or two trades a day or may be hundreds of trades a day. To be glued to a screen, buying and selling on a second by second basis has created a new breed of trader called the scalper.
A scalper looks for a tiny (and I mean tiny) edge in the market. This may mean ‘scratching' (buying and selling at the same price) several trades for every profitable trade.

Many of these scalpers will trade spreads between either different products in the same asset class or indeed different futures months within the same product. This spread trading requires immense concentration as a badly timed tea break could prove expensive!

A short term interest rate futures contract, for example, will have several months available to trade. Day traders will study the fair value of one month against another (spread) and when a big order in one of those months moves the price, then there is an opportunity (if you are quick) to trade the other months before they fall in line again. This is where execution technology is crucial, as there may be hundreds of spread traders trying to do the same trade at the same time.
Similarly, some spread traders, will choose to trade one contract against another. For example, it is increasingly popular to trade one index against another: the FTSE Vs Dow seems particularly popular at the moment.

In the equity markets, ‘Pairs' trading is common place, whereby a trader will find a stock within a sector that he feels is strong, go long, and hedge it by shorting a stock within the same sector that he feels is relatively weak. So he is protected against a sector fall out and hopes that the spread between the two stocks will widen/narrow in his favour.

Another favourite is in the oil market, where the ‘crack spread' is a specific spread trade involving simultaneously buying and selling contracts in crude oil and one or more of the refined products, typically gasoline and heating oil.

Here are two charts: one of the Dow and one for the FTSE 100, over the same period, which was 04/12/09 from 1430 to 1630 (UK Time)

You can see that both Indices moved in a similar direction in each 5 minute period, which is represented by each bar on the chart.
In this instance, the Dow moved and the FTSE followed. This a common theme for the FTSE, once the Dow opens at 1430 every afternoon, and many traders see this correlation as an edge.
Quite simply they will watch the Dow, and I mean watch (without blinking sometimes!) until it suddenly moves, then jump on a trade on the FTSE, knowing that it will most likely follow the Dow.

We saw this at 1500 above, when the Dow moved sharply downwards and the FTSE followed. Looks easy, but you have to be quick with the right technology that will not re-quote you.

Look again at the last 20 minutes (4 bars) on the FTSE chart and you will see that it takes a mind of its own and trades down to the close at 1630, when the Dow stayed steady over the same period.
There could have been a number of reasons for this, but my odds on favourite is the day traders were long and needed to sell to close their positions for the day.

Many think trading is a zero sum game, meaning for every winner there is a loser. But I don't think this is the case, because you may have a short term day-trader selling to pension fund; the day trader looking for a few points profit and the pension investing its premiums for long term growth.

Whatever your style, there is no such think as free money; but day-trading can give you an edge and at least allows you to go home and sleep at night, without being exposed to the sharp moves from the other side of the pond.

Simon Brown
Managing Director
ProSpreads