In essence, volatility is a measure of how much and how fast prices are likely to change. Will MSFT (Microsoft), currently at $27 increase to $28 in the next hour, or fall to $26? Does it continue to fluctuate like that for the day, or several days? Those are wide price swings in a short period - hence high volatility.

The issue is important since, if the price changes slowly, investors will have time to react. If the price changes by an extremely small amount, there is little to lose or gain. Both factors are important in measuring risk.

Mathematicians and options researchers being restless and curious people have naturally not stopped there. They’ve devised several different ways of defining and measuring volatility.

The most basic uses a statistical concept called ’standard deviation’. While the calculation is complex, the idea is simple. It’s basically just a measure of how far from an average a certain amount differs (i.e. deviates). That calculation, carried out for data covering a year and then massaged a bit, becomes the figure shown in charts.

A variation on that number, called Implied Volatility (IV), uses factors you would intuitively expect: market price, strike price, expiration date, interest rate.

Why should a trader care?

One reason is that IV tends to increase when the market is bearish and decrease when the market is bullish. Common sense reveals why.

If it’s August in the Northern Hemisphere, say New York, and the temperature is 80 degrees (Fahrenheit), how likely is it to deviate to below 40 at noon? If it’s late February, 40 degrees at noon isn’t at all unlikely, but in August it would be surprising.

That deviation from the norm, and the measurement of its likelihood forms the basis of betting on future movements. (In fact, there are option-like derivatives known as Weather derivatives that do just that.)

If it were August in New York, traders would be bullish that it would rise above 70F. (It often does.)

How can a trader use volatility in evaluating trades?

Volatility is one common measure of risk and options are fundamentally about trading risk. One of the most widely used gauges of that volatility is VIX (Volatility Index). First developed by the CBOE (Chicago Board of Exchange), it’s calculated using a weighted average of implied volatility. The data forming that average comes from a wide variety of strike prices for calls and puts from the S&P 500.

Traders use VIX to gauge market sentiment, with a range of 20-25 indicating a probably sell-off. VIX increases as the market goes down and decreases when the market moves up. Again, common sense suggests an obvious reason.

Since volatility implies uncertainty, traders tend to be less concerned about a rising stock market than a falling one. Though shorting certainly forms part of many trading strategies, most traders look to gain from higher prices, not lower.

The higher the perceived risk, the higher the implied volatility and the more expensive options become. As the market declines, puts become more popular. Since traders generally expect the trend to continue (at least in the short term), committing to buy at a lower price becomes a preferred position. Higher demand means higher prices - in this case, for puts.

Tracking volatility should form part of any trader’s strategy. Fortunately, one doesn’t have to be a mathematician to incorporate this tool. Software that calculates and tracks the common measures of volatility are readily available. Add it to your toolbox.

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Volatility

When buying stocks you’re making an investment in a company. Buying shares is short for ‘purchasing a share of ownership’. By contrast, no one is making an investment in Japan by buying yen. We leave aside politically motivated actions by large central governments. Currency is exchanged in order to facilitate the movement of goods and the payment of services between multiple countries, but that’s a relatively small percentage of the total $2 trillion daily volume. The largest amount is simple speculation.

Well, perhaps not very simple. Trading euros against dollars against yen against pounds against… in a twenty-four hour market with a dozen time zones… it gets complicated.

Margin differences between the two markets are enormous. Most stock brokers will leverage (lend investors money) up to 2:1. In currency trading 100:1 is common. Since price movements occur twenty-four hours per day every day, margin calls can occur while the investor is sleeping. That makes for a bad awakening.

Trading cycles are generally much shorter. Stock investments are made, even by professionals, on timelines of months or years. Currency trades are often completed within a day or even minutes. Yes, that happens in the equities markets, too. But, it isn’t the norm even though it’s more common than ever.

All these differences suggest some lessons for the investor interested in forex trading.

Do your homework.

Be aware of factors affecting currency rates. That includes not only the standard domestic economic indicators, but trade imbalance figures, central bank policy changes and others.

Watch the market.

Small, rapid changes can force your position into an area that motivates your broker to execute a margin call. Be prepared to cover your position or liquidate at times favorable to you. Know the broker’s margin call policy and practice. You’ll be required to sign a margin agreement when opening an account. Read it first.

Practice.

When starting out, take advantage of the demos offered by most brokers. Execute paper trades - trades that don’t execute on the real markets - using the real currency figures.

Get a feel for the amounts, the percentage changes and get used to converting currencies from one country to the next. You should be able to estimate without much thought how much 1,000 pounds is in dollars at the current exchange rate.

Opinions and size don’t matter.

Unlike stock markets, the size and complexity of the forex markets makes it virtually impossible for any investor, no matter how large, to dominate the price. Program trading, fund trading and so on that can cause large movements in particular equities has a negligible effect on currency prices.

Similarly, analyst projections have much less influence in currency trading. Many will read eagerly some influential columnist’s opinion of the future of IBM. Opinions of that kind are largely discounted in currency trading.

It’s a different world out there.

There are around 4,500 stocks listed on the NYSE and 3,500 on NASDAQ. And many more on other exchanges. A few hundred are major players. By contrast, only a dozen currencies account for 99% of all trades. With four major markets trading twenty-four hours per day, the action is very concentrated.

No need to be intimidated though. Currency trading has moved in the last decade from the realm of the professional trading millions at a click to mini-accounts of $250.

So, go make some money.

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Currency Trading vs Stock Investments

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Forex Training

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Investment Banking

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Tips for Investors in Homes

Professional athletes are often told by their coaches that their attitudes on the field can affect whether they win or lose. That’s even more true in Forex trading. It sounds like the standard motivational speech, but having the right frame of mind can definitely influence your trading results.

There are many aspects of Forex trading that are outside the investor’s control.

Forex market participants number in the millions - traders for the world’s largest banks, huge governments and individuals just like you. Unlike stocks, even the big traders have a tiny effect on exchange rates.

Even when setting interest rates and other actions that influence inflation, the largest governments can have no immediate impact on exchanges. The Forex markets are simply too large - $2 trillion daily - for any one player to dominate the action.

Trading strategies, which are essential, can increase the odds of making profits and help minimize or avoid losses. They give the knowledgeable trader that tiny edge that can make the difference between winning and losing on a given trade, or over time.

But before looking at market influences, and even before developing a set of technical strategies that help guide trading choices, the novice Forex investor has to honestly and objectively examine his or her own attitudes.

Forex is fast-paced, complicated and requires a well-thought out game plan. That game plan has to be executed with nerve and skill. Trading successfully in a demo account for several weeks is essential but can lead to unwarranted confidence. Traders who invest Monopoly money will often take chances, leading to successful trades, that they wouldn’t dream of taking with real money.

Real trading requires answering honestly a number of questions that can be difficult to answer objectively when the subject is the self-same trader asking them. What are your financial trading goals? Looking for a quick buck? Seek elsewhere. You will have losses that wipe them out. Looking for secure, low-risk capital accumulation? Try AAA bonds instead.

Forex trading can be simultaneously a stimulating intellectual game and an exciting adventure. The thrill of victory! The despair of (temporary) defeat! The mastery of the intricacies of Fibonacci, Parabolic SAR, Stochastic Oscillators and Doji Stars. All this, and much more, is part of Forex investing.

As a result, you will need to be very frank with yourself and decide how (and whether) you are prepared to deal with pressure and fear. Even professional traders do not have any certain system of ensuring profits and avoiding losses.

The pressure of deciding when to buy and when to sell is many times larger than in stock trading. The fear of loss is greater, in part because of the amplification provided by 100:1 or larger leverage.

Even winning can be problematic. With practice and persistence, provided you don’t quit too soon or run out of money too quickly, you will have periods when it all seems laughingly easy. That can lead to euphoria, which is great. But it can also lead to cockiness, which is fatal. Nothing will wipe out a trader quicker than arrogance. Confidence is essential, vanity is suicidal.

The other side of the coin to be avoided is too much second guessing. Successful trading requires bold moves based on sound judgment and confidence. Every decision is a small leap of faith, since no one can know in advance for certain what the outcome will be. Probability of one degree or another is the best that can be achieved.

All this will be accompanied by the fear of loss of capital, which often leads to panic selling in the face of what would have been a temporary price movement. It is of such panics that depressions are made, both economic and psychological.

Forex is a roller coaster ride. But if you have a good inner ear and a strong stomach, bolstered by the brain of a statistician and the nerves of a pro billiards player, you will be well suited to end the ride with full pockets.

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Trader Psychology

Forex market makers and brokers make money from something called ‘the spread’. It’s important you understand how it works.

Suppose a trader is dealing directly with a market maker. A market maker is an individual or company that directly offers a currency pair trade, as distinguished from a broker who acts as an intermediary. The bid price is that which the market maker offers to BUY the base currency from the trader. The ask price is that which the market maker requires in order to SELL the base currency in exchange for the quote currency.

For example

EUR/USD 1.1900/05 means

If you buy 1 EUR you will pay 1.1905 USD
If you sell 1 EUR you will receive 1.1900 USD

The difference between those two prices is called the SPREAD and it is how market makers (and, indirectly, Forex brokers) make a profit, in stead of charging commissions. In practice, for every seller there must be a buyer for any trade to take place. The broker, acting as an intermediary - unless he or she is also a market maker buying and selling for his or her own account - locates a trading partner.

If you are willing to sell euros at the exchange rate of $1.1900 the broker locates someone willing to buy them at $1.1905. The broker pockets the difference, in stead of receiving an explicit commission.

How does this affect you, the Forex trader? You are paying for the spread, in essence.

Suppose you were to accept the trade and sell euros for dollars. The bid price will apply so you receive 1.1900 dollars for every euro sold. Now suppose you wanted to immediately buy those euros back from your broker. The ask price will apply so you would pay a rate of 1.1905 dollars for every euro acquired. That difference, the spread, is measured in points or pips, in this case 5 pips.

That five point difference would result in an immediate loss to you, even though the exchange rate hasn’t changed by a single pip. You sold euros for 5 pips less ($1.1900) than you bought them for ($1.1905).

Calculated in terms of dollars rather than points, you would lose $5,000 on an immediate trade of 100 lots. $11,905,000 - $11,900,000 = $5,000. At 1/250th leverage, however, this equates to an actual ‘commission’ cost of $5,000/250 = $20.

It’s perfectly legal and ethical. It’s simply the cost (to you) of trading in foreign currency.

As a result of the spread, which accompanies every quote, traders must wait for the market to move by at least that amount just to break even. To profit, the exchange rate must move by more than the spread. Of course, while you wait, the exchange rate can move in either direction and may result in an even greater loss if you liquidate your position.

In our example, you sold euros at 1.1900 and will have to see at least a 6 pip change in ask price (from 1.1905 to 1.1899) before you can buy euros at a profit. Every currency pair price - the exchange rate - moves, by definition and convention, a minimum of 1 pip. You will never see a 1.5 pip change, for example. This minimum is a one point change in the last digit in the price quote.

Of course, actual trading is not so simple. That needn’t be bad, though. That can work for you. Brokers or market makers offer different amounts and types of spread to different customers at different times.

Spreads may, and often are, narrower for those who have a 100K account and larger for those with a mini account. You put more money into the game and you get a better deal. That’s reasonable and normal.

Spreads for a mini account may be as high as 10 to 15 pips, and as low as 5 pips or less for a 100K account. Large banks and institutional traders are typically the only ones to receive ultra-low spreads.

Also, many brokers differ in the terms under which they’ll offer variable versus fixed spreads. For example, a broker might offer a variable, and decreasing, spread as the notional amount of the trade increases.

As an example, you offer to buy 10 standard lots of euros (10 x 100,000 euros x 1.1905 $/euro = $1,190,500) and the spread is, say, 3 pips. If the deal were only for 1 standard lot (100,000 units) the spread might be 5 pips.

Note that because Forex trading is highly leveraged a trader may only have to input 1/250th of the actual amount of dollars. Even that low fraction still amounts to an investment of $4,762 ($1,190,500/250) for 10 standard lots. Though high, that amount is within the reach of many non-professional traders.

Spreads can differ due to a dozen different circumstances. Just as with bonds, mortgage lending and every other form of investing today, the variations are many. Spreads will differ from broker to broker and from trade to trade. They can depend (as we’ve seen) on the amount traded, the established relationship between broker and client, or recent volatility, or current liquidity… The list is endless.

As a result of this, it pays the trader to do some homework and shop around for brokers that offer their clients the best spreads, on average. But beware - cheaper is not always better. Fixed spreads are typically slightly higher than variable, but offer the insurance of locking in a known cost.

It does little good to get great (super-small) spreads if your broker’s execution times are typically bad or if trades are frequently rejected. You want trades made quickly so they can be made as close as possible to the up-to-the-minute price you saw on your screen. You also want a broker who will be honest and ethical and not employ any of the many tricks of the trade for increasing their profits at your expense.

If you make the effort, you will find a broker or market maker who offers honest deals at reasonable spreads. Despite the huge volume of Forex trading (in the neighborhood of a few trillions daily worldwide among thousands of banks), it is still in some ways a small world. Word gets around and a bad reputation can ruin a broker.

Make sure you read the fine print and execute enough demo and small dollar volume trades to get used to Forex trading and how spreads affect your profits and losses. Forex trading is much more complex, volatile and fast-paced than even typical day trading in stocks. An educated investor will suffer fewer avoidable losses.

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Spreads and Investment Costs

Choosing a good Forex broker can be as complicated as Forex trading itself. For that reason, investors should do their homework as diligently as they would for a trade. Here are some tips to keep in mind to make your research and choice easier.

In the U.S., any worthwhile Forex broker will be registered as a Futures Commercial Merchant (FCM) with the CFTC (Commodities Futures Trading Commission). Finding one doesn’t end the need for research, it’s just the bare minimum you should require.

Since Forex trades are highly leveraged (in effect, the broker ‘lends’ an investor up to 99% of the money required to make a trade), the broker you select should be associated with a firm with deep pockets.

Forex accounts are not FDIC (Federal Deposit Insurance Corporation) insured, so you can not expect the U.S. government, or anyone else, to bail out the brokerage firm or reimburse you if the market turns sharply downward. Large institutions, with ample capital to withstand downturns in the market, and rapid drains on their deposits if clients withdraw en masse, are crucial to your financial peace of mind.

Beyond those rock bottom basics there are many options.

Since the Forex markets trade 24 hours per day all around the world, you may want to trade after normal business hours in your home country. Whether your broker resides in the same country (usually, for language and legal reasons) or not, you want one who will pick up the phone when you call.

Forex trading has moved into the Internet age, but it is still very much a phone-based business. Getting a broker on the phone at any time of the day or night can mean the difference between profit and loss. Sometimes, big profit or loss.

Since Forex brokers don’t work off standard commissions the way stock or bond brokers do, you need to research the firm’s spreads. Forex trading is always done in currency pairs. A spread is the difference between the bid and ask price - what the broker pays to buy versus the amount they sell a currency for.

Some brokers will offer fixed spreads on all trades, which has the advantage of predictability. It’s a kind of fixed ‘commission’. But that may or may not suit your trading style or your budget, since they tend to be larger than variable spreads.

Any broker will offer a standard account to a qualified client. Typically you have to fill out an application form that states you have adequate capital and understand the risks involved in Forex trading. Standard accounts trade currency in standard lots of 100,000 units. You can’t buy 100 euros for $150, you have to buy 100,000 euros.

Since that’s a very large investment for the average trader, brokers offer leverage. Professional traders use leverage as well, of course. In other words you put in, say 1% of the total, the broker puts up the rest. That has huge profit (or loss) potential, but it entails significant risk. So be aware of a broker’s margin call policy.

Many brokers today will offer some form of ‘mini’ account. Instead of trading in standard lots, they trade in smaller units, such as 10,000. This lowers the investment required from, say $2,500 to only $250. Most clients can easily meet that minimum.

But that lower leverage requirement limits the potential for profits. That may or may not suit your investment needs. Only you can decide.

You’ll want a broker with software that provides you with the research and other trading tools you will need to be effective in Forex trading. Forex investing is much more complex and volatile than even stock or bond trading, which is already not simple when done well.

Be sure to use the trial accounts offered and make several ‘fake’ trades in order to test out the software and research available. You need real-time prices - Forex moves very fast - and lots of technical and fundamental analysis information at your fingertips.

There are websites and forums where specific brokers are discussed, but take what’s said there with a grain of salt. Just as with complaints about vendors on eBay or Amazon and other large Internet trading arenas, a few bad remarks shouldn’t ruin the reputation of honorable brokers.

Beyond all that, the factors become a little more difficult to judge. Above everything, you want to feel you trust the person on the other end of the line. They are not there to be your friend or listen to personal complaints or trade tips. But you should get the sense that they are competent, professional and ethical.

Take your time to research. After all, your decision will affect ALL your trades.

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Choosing a Forex Broker

An option is a contract giving the investor the right to buy or sell some instrument at a given price on or before a stated date.

Options contracts are written on all sorts of underlying assets: real property, stocks, bonds, even movie screenplays. (Though the latter trade on a rather different sort of exchange…)

The basic idea is simple. Invest a (relatively) small sum today, to control something worth a larger amount today. Bet that the price will move in a given direction before a certain date, then sell and pocket the difference.

For example, suppose Google shares are selling at $400 per share. But buying 1,000 shares of GOOG (the symbol for Google stock) at $400 each would cost $400,000. That’s a substantial investment of cash, one beyond the means of the average investor.

Even buying on margin (borrowing) would typically get you only half the way there. Most stock brokers will lend their clients only up to 50% of the total cost. (There are laws restricting them, in any case.)

But, you can still ‘own’ 1,000 shares of GOOG. Simply buy an option at, say, $20 per share (the ‘premium’). Now your investment is $20,000 - hefty, but within reach. (That’s called ‘leverage’ - controlling more than you own.)

Every option has an expiration date - the date by which the investor must ‘exercise his option’, i.e. execute a decision to buy/sell the instrument or lose his invested money. Depending on the underlying asset, and other factors, the date can be anywhere from a day to several months hence.

Options also have a strike price - the price at which the underlying instrument has to be bought or sold when exercising the option.

Continuing the example, suppose the option for GOOG expires in 30 days and has a strike price of $410. The break-even price would be $410 + $20 = $430 per share. At this point, you are ‘under water’ by $30 per share x 1,000 shares = $30,000. Ouch!

(Note: ‘Under water’ is - obviously - not the same amount as your investment. It’s the amount you have to rise to reach break-even.)

But, three weeks pass and Google announces some good news about earnings. The price per share rises to $440. Now you can exercise your option (’close your position’) and sell.

The options contract price has increased as well, to $25. Your profit is: ($25-$20) x 1,000 = $5,000. (Ignoring broker fees.) Not bad. That’s a 25% profit on a $20,000 investment. (Of course, prices fall as well. More on risk and hedging strategies later.)

Options aren’t for everyone. They’re more complicated (though not too much), riskier, and generally involve shorter term trades and the requirement to watch the market more closely.

But note that purchasing the options contract did NOT involve investing 5% ($20/$400 x 100%) and borrowing 95% of the funds. Options contracts are a straight investment of funds, not a broker loan.

If the price goes in the predicted direction before expiration, you make money. Otherwise, you lose (some or all of) your investment.

As with any investment, do your homework. Make sure you understand how options work and what the relative risks are. In particular, study the market for that type of underlying instrument. Throwing darts blindly is the least successful options trading strategy.

Good luck… or should we say, good research.

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Options 101

Options are frequently used in hedging.

A hedge is an investment made to offset the risk incurred by entering another investment. Ironically, the basic idea is to bet against oneself, in a way.

Speculate that the market price will rise in the future and buy a call today. (A call is an option that confers the right to buy an asset at a set price in the future.) But, knowing that any price rise is uncertain, simultaneously buy a put. (A put is an option to sell at a preset price in the future.)

Now, why would anybody do such a crazy thing?

Well, hedging is, at bottom, a form of insurance. Though there are traders who use it more actively as a profit seeking strategy, such as hedge fund managers. By carefully selecting the appropriate combinations of strike price, expiration date and type of option an investor can minimize risk and maximize the probability of making a profit.

How?

As an example, we’ll consider a common hedging strategy: the Strangle. No, that’s not something you do to your broker. That would be increasing risk, not minimizing it.

In this strategy, an investor holds both call and put options with the same maturity, but with different strike prices.

The contracts are purchased ‘out of the money’ and are therefore cheaper. ‘Out of the money’ means the strike price of the underlying asset is – higher (for a call) or lower (for a put) – than the current market price.

Suppose Microsoft (MSFT) is currently trading at $30 per share. Buy one call at $3 and one put at $2 with the call having a strike price of $35, the put $25. (Total Investment = ($3 x 100) + ($2 x 100) = $500.)

If the price over the length of the contracts stays between $25 and $35 the total possible loss = $500, the cost of the options. Therefore the risk (’exposure’) is limited to $500.

Suppose the price drops near expiration to $15. The call would expire worthless, but the put is worth ($25-$15) x 100 = $1000 - ($2 x 100) = $800. Subtract the cost of the call, $800 - $300 = $500. This represents the net profit (ignoring commissions and taxes) on the trades.

The difference between the exposure and the potential profit represents a kind of hedge. Though the investor is, in a sense, ‘betting’ that the price could go either way, his downside is limited to the combined cost of the put and the call.

There are, not surprisingly, nearly as many hedging strategies as there are investors. A couple of common types are:

The collar: Hold the underlying asset and simultaneously both buy a put and sell a call of the same asset. The short call limits gains, but the long put hedges against any losses from the underlying asset.

The protective put: Buy the asset and also buy a put option on the same asset. At expiration, the asset may have gained (eliminating the value of the put option), but the rise in the asset offsets the loss.

Exotic combinations abound, but most involve speculating on the price direction of the underlying asset, while taking advantage of the leverage, cost and timing characteristics of options. As with any investment strategy, make sure you understand the pros and cons before laying down your bet.

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Hedging, Trim Risks Not Bushes