Thursday, April 29, 2010

Why trading eminis may be a better alternative than trading stocks, part 2

If your stock trading is not going well, and you are falling short of your expectations, SP500 emini trading may be a good alternative choice. This article discusses some reasons why emini trading may be better for you.

When I first began to trade as a teenager, I began with stocks. Over the years I had my share of success and failure. Over time, however, I began to realize that stocks had many different risks associated with them. I realized if I changed my perspective, and looked at the market as a “whole,” that I may be able to avoid some stock specific risks. By moving to the emini market I was able to avoid many of the risks that are specific to individual stocks.

Any type of trading involves uncertainty and risk taking, but understanding the types of risk you are taking can help. Stock trading, in my opinion, requires a trader to undertake some risks that are unacceptable. Most stock investors have probably been burned in the past when a company announced its earnings. Expectations concerning earnings are created and manipulated by analysts, executives of the company, and the press. Lower earnings than expected can lead to trading losses for stock investors. The problem for a stock trader is to define what the expectations are, who is creating them, what the reality is, and how great the differences are between expectations and reality. This belongs in a philosophy class, not trading. (There is nothing like this in trading futures, except, perhaps, for trading economic data releases and Fed rate decisions).

The earnings of a company can also be manufactured. If you have some understanding of financial statements, you will know how easy it is for a company to play around with their numbers. There are many tricks a company can use to change how their earnings are represented. Some examples include: the choice of depreciation schedules, using LIFO or FIFO, loan loss provisions, or moving items off the balance sheet. Moving items off-balance sheet has been one of the main reasons many stock investors were badly burned in the financial sector in the past two years. These examples are the kinds of risks that I find unacceptable to take as a trader. They are incalculable and no one has any idea of what the probabilities of their occurrence are. They are complete unknowns which are very difficult to predict, understand, or avoid when trading stocks.

In addition to undertaking significant risks from changing expectations and financial statement accounting, an investor also faces the possibility of manipulation in the trading of the stock. We have all heard that it is very difficult to manipulate the price of a stock. The general argument goes along the lines that the large number of competing traders and investors create a “fair price.” This may be true to some extent, but nonetheless, the fact remains that large institutional trading firms, particularly hedge funds, account for a significant percentage of the overall trading of stocks. It only takes a few, well- capitalized traders, with the same opinion, to trade large blocks of stock and move a stock’s price. No one trading firm, or group of firms, can manipulate or move the US stock market like they can an individual stock of a company.

Another reason why emini trading is preferable is that it is an extremely liquid market. Most of the Dow or SP500 stocks have excellent liquidity, but, smaller stocks may or may not. The amount of liquidity in a stock is important because it can affect your entry and exit prices. The amount of slippage is important to your bottom line. I am not stating that there is no slippage in the eminis; all trading involves slippage. But what I am stressing is that a trader undertakes greater risks in the amount of slippage when trading less liquid stocks. Liquidity is never an issue with the SP500 emini market.

Next, I would like to address shorting. Futures traders generally play both sides of the market. This is not necessarily true with stock traders. In my opinion, most small time investors and traders are only taking long positions. Not shorting a market, or a stock, is similar to playing half the game. Shorting stock, however, is more difficult for the smaller trader. Brokers place a variety of restrictions on smaller traders, such as their net worth and larger margin requirements. In addition, newer trading rules, such as being defined a “daytrader,” place additional limits and restrictions on smaller traders. If a trader is permitted to short stocks, they also may face additional limitations in finding the stock to short. All of these requirements, risks, and limitations can be avoided with futures trading. Trading futures from the short side is much easier than shorting stocks.

Lastly, capital gains on futures are taxed more favorably than capital gains on stocks. Relative commission rates may also be lower for futures. In conclusion, there are many reasons why emini trading can be a better alternative to stocks, and I would recommend that stock traders consider the possibility of trading emini futures.

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