Why Day Trading Stocks is SO Risky
Day Trading 101 … why futures trading may be better than stock trading…
If the economy is in a growth mode, odds are typically favorable for buying stocks. Average returns every year are close to +10%. This tells us day traders buying stocks each day on average have a possible 50% chance to make a profit. Utilizing statistical analysis to gather data for proper buy and sell entry signals could improve the odds into 70 % for profitability. There will be losses though, most new traders lose money in their account for various reasons. They buy every lift, get stopped out on reversals, short into it and get stopped out on the next leg up. Algos own these ups and downs. Trading stocks also comes with bid ask spreads, news announcements, earnings shortfalls, insider trading, copywrite infringements, weak human company leadership and lawsuits. These variables can ruin a perfect trend day.
To eliminate the noise mentioned above in single stock trading, professional traders turn to the futures market. This allows you to trade the direction of the stocks without individual insider news affecting the trend. With futures you can be involved in any asset class.
Advantages to futures trading
Higher leverage than stocks
Leverage in the futures market is due to the lower amount of cash needed to secure the position. Typically in the futures market this runs 2–12% of the value of the underlying index, bond or commodity. The 10 year treasury note has an underlying value of $100,000 USD, the margin required to place this trade is $2200 or 2.2% margin, whereas if you bought AAPL at $130, you need $13,000 (100%) for 100 shares or $6500 (50%) if you trade with margin.
If the 10 year treasury note future rallies up approximately 1% after you bought it, the trade made close to $1000 for you. If APPL trades up 1% from 130 on the 100 shares bought at $130, you make $130. You put up $6500 to $13000 to buy those shares, whereas you made close to $1000 on the $2200 you put up for margin on the 10 year future.
Higher liquidity than stocks
Futures contracts are standardized. This makes them easy to understand for institutional and retail investors. There are other factors that contribute to the high liquidity in the futures markets:
- mix of commercial/speculative investors
- futures contracts are listed on government regulated exchanges
- they offer high degree of transparency, even showing the depth of order book
- secure delivery of underlying or cash on expiry
- efficient pricing (program traders keep the basket of stocks equal to the S&P 500 Index)
- ability to trade large or small volumes
Many pundits are often critical of the speculative traders and investors, but it may be said they are needed to enhance the liquidity the futures markets. They help with price discovery. When the poor weather influences the ability of farmers to feed cattle, this in turn may lead speculators to drive down the price of beef to a level commercial buyers are willing to step in and make purchases. In a self-fulfilling prophecy, greater liquidity attracts day traders, which improves liquidity and attracts more traders. With liquidity, often the futures markets have the bid ask spread of just one tick.
Information flow more transparent than equities, less susceptible to insider trading
The subject of insider trading involves non-public information which may or may not impact the value of an asset. As the more popular futures markets tend to concentrate on asset classes as opposed to individual companies, they tend to be less susceptible to insider trading. Consequently, the value of futures contracts is seen by many as more transparent than individual stocks. This attracts a greater degree of confidence, and confidence leads to increased volume.
The movement in an index for example will reflect the movement in the underlying constituents of the index. The movement of a stock price or a stock traded option will reflect the movement of an individual company and is, therefore, more susceptible to insider trading. Regular examples of insider trading tend to revolve around corporate activity in areas including:
- Law suits or contract negotiations
- Takeovers and mergers
- New product announcements or failures
- Company results
- Financial issues
Nearly open 24 hours a day
If you take a look at the world equity markets, you will see they open and close at different times, financial markets really never sleep. Just as the US closes, Japan is close to their open. When Japan is closing, the European markets are ready to begin trading. The open times for stocks and stock options mirror the times for the local market. For example, the US stock traded options market is open during normal US trading hours, though some extended hours do apply. The futures market actually trades around the clock, 24 hours, from Sunday evening at 6PM EST to Friday afternoon at 5PM EST. There are short breaks of most contracts between 5–6PM EST.
If you were short the Micro E-mini S&P 500 futures, and there was a significant economic/political announcement outside of regular US market hours, you could capture a profit or lose based on the new information. From Sunday evening until Friday, no matter the time of day, you could trade your futures contract. If you are long or short stock or stock traded options, you would not be able to react to news outside of regular or extended market hours. Being invested in the stock or stck options could represent a missed opportunity; by the time the markets open, the opening stock price/traded option price would already reflect the news. Too late for for you to respond.
No short selling rules
There are no restrictions when it comes to short-selling futures contracts. You are simply required to be trading on the margins, for example, around $2000 for one contract in the CBT 10 year Treasury Note, with the exact amount depending on movement and volatility in the underlying asset. This is a very efficient way to short a particular asset, more traditionally an index, though the U.S. Treasuries are the most traded contracts in the world.
If you want to short sell a stock, you would need to borrow the stock to hold as collateral. The stock will be borrowed from third parties, where there is a borrowing cost and additional margin to pay. As some stocks are more liquid than others, you may have difficulty borrowing sufficient stock at the right price. You also have to transact the stock short sell on at uptick, whereas futures do not have this requirement and can be sold short on the bid. So we see in the futures market there are no additional charges or time value involved.
Lower capital requirements
Futures trading, as covered above in the leverage discussion and the below in pattern day trading rules, has a lower degree of capital requirements. There is a high degree of risk and you should take a cautious approach in regards to over-leveraging your positions, but there is potential to start trading with as little as $2500 in your account.
There are futures brokers who will allow you to open an account by depositing just $1000, others may require $5000 or more. When looking to execute trades in the futures markets, not only will you examine the relatively small amount needed to open some accounts, you will also need to consider the margin requirement on different futures contracts. The relatively small foreign-exchange micro-contracts will require a margin of less than $1000. However, some of the larger contracts, such as the E-mini S&P 500 futures contract, will require approximately $10,700. The micro E-mini S&P is around 20% of that at $2200.
No Pattern Day Trading rules
SEC regulations prohibit traders/investors executing four or more day trades over five business days, using a margin account, without the minimum $25,000 deposit. Traders who make these day trades (in an out on the same day or over the 5 business days) will be classified as Pattern Day Traders (PDT). Consequently, they will be required to deposit $25,000 into their margin accounts. If the margin account balance falls below $25,000, their dealings will be restricted until further funds are deposited. Futures contracts and futures options are not part of the SEC day trade rule.
Enhanced tax treatment
Day trading any asset class, involves a larger cut to Uncle Sam because the U.S. investment game is geared toward longer term holding. The banks make more money in the long run if they control your money for longer periods. For futures trading, current US tax law tells us short-term capital gains are applicable with the 60/40 rule. What this means is 60% of the gain is taxed at the long-term capital gains tax rate of 15%, while the other 40% is taxed at the individual’s income tax rate.
Trading in stocks and ETFs where there are short-term gains are excluded from the 60/40 rule. Traders or investors with gains or profit of less than one year will be taxed at their ordinary income tax rate. Short-term trading of equity options should see the capital gains benefit under the 60/40 rule.
As we see there are benefits when trading options or futures contracts, which benefit from the 60/40 rule, as opposed to stocks and ETFs. The 60/40 mix significantly lowers the tax consequences for those in short term trading and gains.
