Many people give little thought to life’s important decisions. They stumble into them by accidents of geography, time, or chance. Where to live, where to work, what markets to trade—many of us decide on a whim, without much serious thought. No wonder so many are dissatisfied with their lives. You can choose your markets on a whim or pause to think whether to trade stocks, futures, or options. Each of those has pluses as well as minuses. Successful traders are rational people. Winners trade solely for the money, while losers get their kicks out of the excitement of the game.
Where those kicks land is another question. In choosing a market to trade, keep in mind that every trading
vehicle, be it a stock, a future, or an option, has to meet two criteria: liquidity and volatility. Liquidity refers to the average daily volume, compared with that of other vehicles in its group. The higher the volume, the easier it is to get in and out. You can build a profitable position in a thin stock, only to get caught in the door at the exit and suffer slippage trying to take profits. Volatility is the extent of movement in your vehicle. The more it moves, the greater the trading opportunities. For example, stocks of many utility companies are very liquid but hard to trade because of low volatility—they tend to stay in narrow price ranges. Some low-volume, low-volatility stocks may be good investments for your long-term portfolio, but not for trading. Remember that not all markets are good for trading simply because you have a strong opinion on their future direction. They also must have good volume and move well.

STOCKS

Stock Market

A stock is a certificate of company ownership. If you buy 100 shares of a company that issued 100 million shares, you own one-millionth of that firm. You become a part owner of that business, and if other people want to own it, they will have to bid for your shares, lifting their value.
When people like the prospects of a business, they bid for its shares, pushing up prices. If they don’t like the outlook, they sell their stock, depressing prices. Public companies try to push up share prices because it makes it easier for them to float more equity or sell debt. The bonuses of top executives are often tied to stock prices.
Fundamental values, especially earnings, drive prices in the long run, but John Maynard Keynes, the famous economist and a canny stock picker, retorted “In the long run we’re all dead.” Markets are full of cats and dogs, stocks of unprofitable companies that at some point fly through the roof, defying gravity. Stocks of sexy new industries, such as biotechnology or the Internet, can fly on the expectations of future earnings rather than on any real operating records. Each dog has its day in the sun before reality sets in. Stocks of profitable, well-run companies may drift sideways to down. The market reflects the sum total of what every participant knows, thinks, or feels about a stock, and a declining price means large holders are selling. The essential rule in any market is “It’s OK to buy cheap, but not OK to buy down.” Don’t buy a stock that’s trending lower, even if it looks like a bargain. If you like its fundamentals, use technical analysis to confirm that the trend is up.
Warren Buffett, one of the most successful investors in America, is fond of saying that when you buy a stock, you become a partner of a manic-depressive fellow he calls Mr. Market. Each day Mr. Market runs up and offers either to buy you out of business or to sell you his share. Most of the time you should ignore him because the man is psychotic, but occasionally Mr. Market becomes so terribly depressed that he offers you his share for a song—and that’s when you should buy. At other times he becomes so manic that he offers an insane price for your share—and that’s when you should sell.
This idea is brilliant in its simplicity, but hard to implement. Mr. Market sweeps most of us off our feet because his mood is so contagious. Most people want to sell when Mr. Market is depressed and buy
when he is manic. We need to keep our sanity. We need objective criteria to decide how high is too high and how low is too low. Buffett makes his decisions on the basis of fundamental analysis and a fantastic gut feel. Traders can use technical analysis. Speaking of gut feel, this is something that an investor or a trader may develop after years of successful experience. What beginners call gut feel is usually an urge to gamble, and I tell them they have no right to a gut feel.
What stocks should we trade? There are more than 10,000 of them in the United States, with even more abroad. Peter Lynch, a highly successful money manager, writes that he only buys stocks in companies that are so simple that an idiot could run them—because eventually one will. But Lynch is an investor, not a trader. Stocks of many companies with little fundamental value can embark on fantastic runs, making
heaps of money for bullish traders before collapsing and making just as much money for the bears.
The stock market offers a wealth of choices, even after we cut out illiquid or flat stocks. You open a business newspaper, and stories of fantastic rallies and breathtaking declines leap at you from the pages.
Should you jump on the bandwagon and trade stocks in the news? Have they moved too far from the gate? How do you find future leaders? Having to make so many choices stresses beginners. They spread themselves thin, jumping between stocks instead of focusing on a few and learning to trade them well. Newbies who cannot confidently trade a single stock go looking for scanning software that will let them track thousands. In addition to stocks, you can choose from their kissing cousins, mutual funds, called unit trusts in Europe. Long-term investors tend to put money into diversified funds which hold hundreds of stocks. Traders tend to focus on sector funds that let them trade specific sectors of the economy or entire countries. You pick a favorite sector or country and leave individual stock selection to the supposedly hot-shot analysts laboring at those funds.

FUTURES

Futures Market

Futures look dangerous at first—nine out of ten traders go bust in their first year. As you look closer, it becomes clear that the danger is not in futures but in the people who trade them. Futures offer traders some of the best profit opportunities, but the dangers are commensurate with rewards. Futures make it easy for gamblers to shoot themselves in the foot, or higher. A trader with good money management skills needn’t
fear futures. Futures used to be called commodities, the irreducible building blocks of the economy.  Old-timers used to say that a commodity was something that hurt when you dropped it on your foot—gold, sugar, wheat, crude oil. In recent decades many financial instruments began to trade like commodities—currencies, bonds, stock indexes. The term futures includes traditional commodities along with new financial instruments.
A future is a contract to deliver or accept delivery of a specific quantity of a commodity by a certain date. A futures contract is binding on both buyer and seller. In options the buyer has the right but not an obligation to take delivery. If you buy a call or a put, you can walk away if you like. In futures, you have no such luxury. If the market goes against you, you have to add money to your margin or get out of your trade at a loss. Futures are stricter than options but are priced better for traders.
Buying a stock makes you a part owner of a company. When you buy a futures contract you don’t own anything, but enter into a binding contract for a future purchase of merchandise, be it a carload of wheat or a sheaf of Treasury bonds. The person who sells you that contract assumes the obligation to deliver. The money you pay for a stock goes to the seller, but in futures your margin money stays with the broker as a security, ensuring you’ll accept delivery when your contract comes due. They used to call margin money honest money.
While in stocks you pay interest for margin borrowing, in futures you can collect interest on your margin. Each futures contract has a settlement date, with different dates selling for different prices. Some professionals analyze their differences to predict reversals. Most futures traders do not wait and close out their contracts early, settling profits and losses in cash. Still, the existence of a delivery date forces people to act, providing a useful reality check. A person may sit on a losing stock for ten years, deluding himself it is
only a paper loss. In futures, reality, in the form of the settlement date, always intrudes on a daydreamer.
To understand how futures work, let’s compare a futures trade with a cash trade—buying or selling a quantity of a commodity outright. Let’s say it’s February and gold is trading at $400 an ounce. Your analysis
indicates it is likely to rise to $420 within weeks. With $40,000 you can buy a 100-ounce gold bar from a dealer. If your analysis is correct, in a few weeks your gold will be worth $42,000. You can sell it and make a $2,000 profit, or 5 percent before commissions—nice. Now let’s see what happens if you trade futures based on the same analysis.
Since it is February, April is the next delivery month for gold. One futures contract covers 100 oz. of gold, with a value of $40,000. The margin on this contract is only $1,000. In other words, you can control $40,000 worth of gold with a $1,000 deposit. If your analysis is correct and gold rallies $20 per oz., you’ll make roughly the same profit as you would have made had you bought 100 oz. of gold for cash—$2,000.
Only now your profit is not 5% but 200%, since your margin was $1,000. Futures can really boost your gains!
Most people, once they understand how futures work, are flooded with greed. An amateur with $40,000 calls his broker and tells him to buy 40 contracts! If his analysis is correct and gold rallies to $420, he’ll make $2,000 per contract, or $80,000. He’ll triple his money in a few weeks! If he repeats this just a few times, he’ll be a millionaire before the end of the year! Such dreams of easy money ruin gamblers. What, if anything, do they overlook? The trouble with markets is that they don’t move in straight lines. Charts are full of false breakouts, false reversals, and flat trading ranges.
Gold may well rise from $400/oz. to $420/oz., but it is perfectly capable of dipping to $390 along the way. That $10 dip would have created a $1,000 paper loss for someone who bought 100 oz. of gold for cash. For a futures trader who holds a 100 oz. contract on a $1,000 margin that $10 decline represents a total wipeout. Long before he reaches that sad point, his broker will call and ask for more margin money. If you have committed most of your equity to a trade, you’ll have no reserves and your broker will sell you out. Gamblers dream of fat profits, margin themselves to the hilt, and get kicked out of the game by the first wiggle that goes against them. Their long-term analysis may be right and gold may rise to its target price, but the beginner is doomed because he commits too much of his equity and has very thin reserves. Futures do not kill traders—poor money management kills traders.

OPTIONS

Options Market

An option is a bet that a specific stock, index, or future will reach or exceed a specific price within a specific time. Please stop and reread that sentence. Notice that the word specific occurs in it three times. You must choose the right stock, predict the extent of its move, and forecast how fast it’ll get there. You must make three choices—if you’re wrong on just one, you’ll lose money. When you buy an option, you have to jump through three hoops in a single leap. You have to be right on the stock or the future, right on its move, and right on its timing. Ever tried tossing a ball through three rings at an amusement park? This triple complexity makes buying options a deadly game.
Options offer leverage—an ability to control large positions with a small outlay of cash. The entire risk of an option is limited to the price you pay for it. Options allow traders to make money fast when they’re right, but if the market reverses, you can walk away and owe nothing! This is the standard flow of brokerage house propaganda. It attracts hordes of small traders who cannot afford to buy stocks but want a bigger bang for their buck. What usually gets banged is the option buyer’s head. My company, Financial Trading, Inc., has been selling books to traders for years. Whenever a person comes back to buy another book, it is a sign that he is active in the markets. Many clients buy books on stocks or futures every few months or years. But when a first-time buyer orders a book on options, he never returns. Why? Does he make so much money so fast that he doesn’t need another book? Or does he wash out?
Many beginners buy calls because they can’t afford stocks. Futures traders who get beat up sometimes turn to options on futures. Losers switch to options instead of dealing with their own inability to trade. Using a shortcut to weasel out of trouble instead of facing a problem never works. Successful stock and futures traders sometimes use options to reduce risks or protect profits. Serious traders buy options rarely and only in special situations, as we will see later in this book. Options are hopeless for poor people who use them as substitutes for stocks because they can’t afford the real thing. Professionals take full advantage of starry-eyed beginners crowding into options. Their bid-ask spreads are terrible. If an option is bid 75 cents, offered at a dollar, you are 25% behind the game as soon as you buy. The expression “your loss is limited to what you paid for an option” means you can lose 100%! What’s so great about losing everything?
A client of mine was a market-maker on the floor of the American Stock Exchange. She came to my classes on technical analysis because she was pregnant and wanted to get off the floor and trade from home. “Options,” she said, “are a hope business. You can buy hope or sell hope. I am a professional—I sell hope. I come to the floor in the morning and find what the public wants. Then I price that hope and sell it to them.”
Professionals are more likely to write options than buy them. Writing is a capital-intensive business. You need hundreds of thousands of dollars to do it right, and most successful options writers operate with millions. And even theirs is not a risk-free game. Several years ago a friend who used to be one of the nation’s top money managers landed on the front page of The Wall Street Journal after he lost 20 years’ worth of profits in a single bad day of writing naked puts.
There are two types of option writers. Covered writers buy a stock and write an option against it. Naked writers write calls and puts on stocks they don’t own, backing their writes with cash in their accounts. Writing naked options feels like taking money out of thin air, but a violent move can put you out of business. Writing options is a serious game, suitable only for disciplined and well-capitalized traders. Markets are like pumps that suck money out of the pockets of the poorly informed majority and pump it into the pockets of a savvy minority. People who service those pumps, such as brokers, vendors, regulators, and even janitors who sweep exchange floors, are paid from the stream of money flowing through the markets. Since markets take money from the majority, pay help, and give what’s left to the savvy minority, the majority, by definition, must lose. You can be sure that whatever the majority of traders does, believes, and says, is not worth doing, believing, and saying. You have to stand apart from the crowd in order to succeed. Smart traders look for situations where a large majority does something one way, while a small, moneyed minority goes the opposite way.
In options the majority buys calls and, to a lesser degree, puts. The insiders almost exclusively write options. Professionals use their heads, while amateurs are driven by greed and fear. Options take full advantage of those feelings. Greed is the engine of option-selling propaganda. You must have heard the slogan: “Control a large block of stock with just a few dollars!” An amateur may be bullish on a $60 stock, but doesn’t have $6,000 to buy 100 shares. He buys some $70 calls with two months of life left in them for $500 each. If that stock rises to 75, those options will acquire $500 of intrinsic value, while maintaining some time value, and a speculator can double his stake in a month! The amateur buys calls and sits back to watch his money double. Strange things begin to happen. Whenever the stock rises two points, his calls go up only one, but when the stock falls or even pauses, his calls fall briskly. Instead of seeing his money double in a hurry, the amateur is soon staring at a 50% paper loss, while the clock starts ticking louder and louder. The expiration date is nearing, and even though the stock is higher than it was when he bought his calls, they are now cheaper, showing a paper loss. Should he sell and salvage some money or hold and wait for a rally? Even if he knows the right thing to do, he’s not going to do it. His greed does him in. He hangs on until his options expire worthless.
Another great motivator for buying options is fear, especially in options on futures. A loser takes a few painful hits—his analysis was wet and money management nonexistent. He sees an attractive trade but fears losing. He hears the siren song—“unlimited gains with limited risk”—and buys options on futures. Speculators buy options like poor people buy lottery tickets. A person who buys a lottery ticket risks 100% of what he paid. Any situation where you risk 100% looks like an odd case of limited risk. Limited to 100%!?! Most speculators ignore this ominous figure. Option buyers have a dismal track record. They may make a few dollars on a few trades, but I’ve never seen anyone build equity buying options. The odds in this game are so bad that after a few trades they are sure to kick in and destroy a buyer. At the same time, options have a high entertainment value. They provide a cheap ticket to the game, an inexpensive dream, just like a lottery ticket.

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