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One of the great benefits of quantitative trading models is that they can be backtested against historical price data to measure past performance. A great excercise is to find a strategy that you’re interested in (published somewhere, for example Futures & Options Trader magazine) and perform the backtest yourself. You should get the same results as the they did – this will ensure that you understand the strategy correctly and have avoided common pitfalls.

Historical Data

There are numerous sites offering various levels of quality historical stock price data. Below you can find some common sources of free historical data. Google is also your friend here, there’s lots of datasources out there.

Our aim will be to minimize costs

So you want to get started in algo-trading huh? While the start of an algo-trading operation may seem like a daunting task, it can be possible to beat the institutional traders at their own game (or at least share in the profits), have fun and learn an immense about trading the markets autonomously in the process. That is what this post will be about, searching for quantitative strategies and a systematic approach to starting an algorithmic trading operation.

What this post will aim to do is explore the journey of the trading business startup, from finding a viable trading strategy, backtesting it for verification on historical performance, setting up the tech-infrastructure (low-cost!) and building and deploying an automated trading system (ATS) to execute your strategy.

If, like me, you prefer using Linux (personally I’m a fan of the Kubuntu Hardy Heron flavor), you will need to install a virtual machine such as vmware to run a copy of Windows. While OpenOffice is a great solution, from personal experience I have found that Excel really is the best solution when it comes to complex spreadsheets involving macros. If you’re a die-hard OpenOffice Calc fan, go ahead and try it’s macro language but be warned, its not pretty (and not compatible with Visual Basic).

Other than that we’ll be looking at using Matlab or using its cheaper alternative, R for the backtesting of some quantitative trading strategies.

Being proficient at basic stats and basic programming will definitely help, but you won’t need a PhD to put the theories into practice. Strategies will mostly be of the quantitative nature e.g. statistical arbitrage, and the aim is to keep things simple for now. StatArb deals with the simplest financial instruments: stocks, futures and sometimes currencies.

Let’s look at the process of developing a successful trading strategies and putting it into action!

Finding A Quantitative Strategy That Works (And Suits You!)

Unlike popular opinion would suggest, many strategies are publicly available and while they may not be super-profitable can be tweaked to become profitable.

The key is to backtest strategies for historical performance, thereby verifying that they represent a sound hypothesis. While this alone does not guarantee a profitable strategy, it is certainly a very good indication on the future success of a strategy.

Key things to consider when deciding on a suitable strategy are:

• Available time: If you’re working full time and only able to trade part time, you probably don’t want to trade intraday strategies but rather stick to ones that trade overnight. Quantitative trading lends itself well to automation in this regard, since the computer can handle most things automatically, if set up correctly.
• How programmatically inclined you are: Knowing some languages like Java, C# or C++ will definitely be a huge plus when it comes to algo-trading (after all its not called ‘algorithmic trading’ for nothing – trading algorithms are just computer programs firing off buy and sell orders to the markets.
• Trading capital: Depending on your level of available capital, you may not be in a position to trading algos in the first place. Your capital will determine alot of things such as what type of accounts you’ll be setting up, brokerage discounts (based on volume traded), etc, etc. Generally, the more you have to begin trading with, the better.
• Does it have a high Sharpe ratio?
• Does it outperform a benchmark? (Say the ASX/S&P200 Index)
• Does it have small enough drawdown and short enough drawdown duration?
• Does the strategy’s historical performance start declining towards the more recent years compared to that of the earlier years?

Its All About The Odds…

Las Vegas. Great food, show girls, and a multi-billion dollar gambling
business. The money made by the casinos is only matched by the profits
on Wall Street. And the profits of both are based on mathematical probabilities.

Casinos make money because “the odds” or a game’s expectancy are in the house‘s favor. This means that if you play long enough, the casino wins. Over the short term, the casino knows it may win or lose. But if you play long enough, the house always wins. The casinos increase their profits by offering games that are completed in a short period of time – a roll of dice, a spin of a wheel or a few cards turned over.

What does this have to do with trading systems?

• We want the odds of a trade to favor us – We want a positive expectancy
• We want a lot of trades – opportunity
• We want turn over so we can compound the profits – holding time.

What we as traders must do is become the house. The odds in our trading
must favor us, we need a reasonable number of trades during the year
and the trades must be completed in a reasonable amount of time for
compounding to be effective.

Expectancy is simply the product of your profit percentage per win and
your win rate minus the product of your loss percentage per loss and
your loss rate, or:

Expectancy, E = (Ave. Win Size * % Wins) – (Ave. Lose Size * %
Losers)

For example, if we have the results of backtesting a purely
technical system, with the following results:

• Win percentage 6%
• Win rate 60%
• Loss percentage 4%
• Loss rate 40%

The expectancy is 2.0% per trade, or (6% x 60%) – (4% x 40%).

That means, on an average trade, 2% of the money traded is yours to
keep. That’s better odds than a casino gets on blackjack. Now,
that may not sound like a lot of money. If your average trade is $10,000
– 2% is $200 profit per trade. If you have 300 trades per year,
then you have a $60,000 profit per year with an average trade of only
$10,000. This does not even include the profits if you compounded
the average trade.

If you explore the expectancy formula, you will notice that there is
no one set of numbers that could give a positive expectancy but an infinite
number of sets and therefore an infinite number of trading systems that
could be profitable.

Given that, it is possible to develop systems where the stop-loss is
larger than the profits. The stop-loss is academic, as long as your
profit expectancy is positive.

Here’s another example: we could use a 20% stop loss and a 5%
profit target and come out with the same exact 2% expectancy as long
as my win rate is high enough! An 88% win rate in this example would
yield 2.0%, the result of (5% x 88%) – (20% x 12%).

Or, you could arrive at a positive expectancy with a very low win rate.
One of the more famous expectancy numbers comes from William O’Neil,
advocate of the CANSLIM system and founder of Investors Business Daily.
If we use his stop and target numbers of 8% and 20% and his published
win rate of 30%, the expectancy can be calculated to be: (20% x 30%)
- (8% x 70%) or +0.4%.

The bottom line is: expectancy must be positive if you want to make
a profit over time. Never use a system with a zero or negative expectancy.
You will not win. You cannot beat the house over a long series of bets
or trades. Be the “House”.

No matter what your expectancy is, you will not make a great deal of
money unless you have a lot of opportunities to trade. Again, the casino
analogy. The casino may only make 1-2% per hand of blackjack, but they
turn over those hands very quickly – 30 to 40 hands per hour.
Play blackjack long enough and you will lose over 40% of your money
per hour! No wonder they can offer those wonderful comps.

We now know how to create a method, at least on paper, with a positive expectancy. Let’s say we develop a system with 8% expectancy, but if the system only yielded one trade per year, what good would it be? We might as well just put the money in a savings account. Or, if we had a method that yielded 0.2% per trade, you might pass on it? But what if that system generated 1,000 trades per year? 1,000 times 0.2% becomes serious money in a very short time.

The most overlooked area of trading is the “holding period.”
In order to make money, you must have a system that generates a positive
expectancy and a lot of opportunities. But you must have access
to your money. If your trade’s hold time is too long, you
can’t take advantage of all or even most of your opportunities. Your
trading money or buying power is always tied up because you have to
wait too long to close your trades.

Casino analogy time. If the house odds in Blackjack are 2.5%, that means
for ever $2 bet, the casino makes, on average, 5 cents. If you only
play 1 game per hour, the casino makes 5 cents per hour. If you play
60 games per hour, the casino has all of your $2 in 40 minutes. All
things being equal, the game with the fastest turnover is the more profitable
for the casino.

It’s no different with trading. You will be more profitable with $100,000
that you could “turn” 250 times per year, than $500,000 that
was tied up in one trade for 12 months. As an example, let’s say we
have one trade and that trade yielded a 50% return. You just had a great
year – a $250,000 profit.

On the other hand, say you had $100,000 for stock purchases, and your
expectancy was only 1.2% per trade but you turned over your stocks 250
times in the same year. This method ends up generating $300,000 for
the year, and that assumes you never increase the position size as the
equity grows. You just had a better year. And it is easier to get 1.2%
per trade than 50%.

The bottom line for a great bottom line is:

• A positive expectancy
• A good number of trades
• A short holding period

The Stock Market

The stock market is essentially the term given to the place
where traders and investors can buy and sell stocks through
agents known as brokers. This takes place in a very similar
fashion to that of a cattle market or any other livestock market for
that matter, in that prices vary on a constant basis according to
supply and demand.

As more people want to buy a stock and less people are willing to sell it, the price rises until more sellers are tempted by the higher prices on offer and the relationship returns to a state of equilibrium. Equally, if the circumstances change and the stock loses favour with investors, causing the rate of selling to increase and buying to decrease, then prices will drop until they reach a level which entices investors back into the stock because they feel it is now good value for money. We will show some of the ways you can determine how fairly valued a stock is later, though this is often described as more of an art than a science.

The Stock Exchanges

The places where stocks and other securities such as options and
futures are traded is known as an exchange. There may only
be a single exchange making up the stock market for a country,
or in some cases there may be numerous exchanges within one domestic
market. For example, in the US there are three main exchanges:

• The American Stock Exchange (AMEX)
• The New York Stock Exchange (NYSE); and
• The National Association of Securities Dealers Automated Quotes
  (NASDAQ).

There are also a number of regional exchanges including the Chicago
Stock Exchange (CHX) and the Pacific Stock Exchange (PSE) in addition
to the three main exchanges above.

Some major exchanges in other worldwide markets include:

Australia

The Australian Securities Exchange
(ASX)

Great Britain

The London Stock Exchange
(GBX)

India

The National Stock Exchange of
India (NSE)

The Bombay Stock Exchange (BSE)

China

Hong Kong Stock Exchange (SEHK)

Shanghai Stock Exchange (SSE)

Introduction To Futures

A futures contract is a commitment to deliver or
receive a standardized quantity and quality of a commodity (or financial
instrument) at a specified future date. The price associated with
this trade is the trade entry level.

The essence of a futures market is in its name: Trading involves a commodity or financial instrument (you can have futures on stocks for example) for a future delivery date, as opposed to the present time. Thus, if a grain farmer wished to make a current sale, he would sell his crop in the local cash market.However, if he wanted to lock in a price for an anticipated future sale (e.g. the marketing of a still unharvested crop), he would have two options: He could find an interested buyer and negotiate a contract specifying the price and other details (quantity, quality, delivery time, location, etc). Alternatively, he could sell futures. Some of the major advantages of selling futures are:

• The futures contract is standardized
  - this means the farmer doesn’t have to find a specific buyer.
• The transaction can be executed nearly instantaneously
  with a one-line phonecall order (e.g. “Sell 2 March grain
  at the market”).
• The cost of the trade (commissions) is minimal
  compared with the cost of an individualized forward contract (ie.
  if the farmer were to sell to one specific buyer in the future
  via a “contract”).
• The farmer can offset his sale at any time between
  the original transaction date and the final trading day of the
  contract (the reason why he’d want to do this will be discussed
  shortly).
• The futures contract is guaranteed by the exchange.

Until the early 1970’s, futures markets were restricted to commodities
such as wheat, sugar and copper. Three additional market sectors
have been added to the futures area since then: currencies,
interest rate instruments, and stock exchanges.
The same basic principles apply to these non-commodity futures markets.
Trading quotes (futures contract prices) represent prices for a
future expiration date, as opposed to current market prices. These
new financial markets have witnessed spectacular growth since their
introduction and account for approximately two thirds of all trading
volume. In this sense, futures appear to be a far more appropriate
designation than commodities, although the term “commodities”
is still often used when referring to futures (they are considered
synonymous).

Delivery

Shorts who maintain their positions after the last trading day are obligated to deliver the actual commodity (or financial
instrument) against the contract. Similarly,
longs who maintain their position after the last trading day must accept delivery.
In the commodity markets, the number of open long contracts is always equal to the
number of open short contracts (see the Volume & Open Interest section). Most
traders have no intention of making or accepting delivery, and hence will offset
their positions before the last trading day. (Longs offset their position by entering
a sell order, shorts by entering a buy order).

Only a very small fraction of open contracts actually result in delivery. Since
the early 1980s, there has been a strong settlement toward using a cash settlement
(ie. outstanding long and short positions are offset at the prevailing price level
at expiration) instead of a delivery procedure. Most financial contracts and some
commodity-type markets use cash settlement.

Volume & Open Interest

Volume is simply the total number of contracts traded
on a given day. Volume figures are available for each traded month in
a market, but most traders focus on the total volume of all traded
months.

Open interest is the total number of outstanding long
contracts, or equivalently, the total number of outstanding short contracts.
In futures markets, the two are always equivalent. When a new contract
begins trading (normally about 9 – 18 months before its expiration date),
its open interest is equal to zero. If a buy order and sell
order are matched, then the open interest increases to 1. Basically,
open interest increases when a new buyer purchases from a new seller,
and decreases when an existing long sells to an existing short. The
open interest will remain unchanged if a new buyer purchases from an
existing long or a new seller sells to an existing short.

Volume and open interest are very useful as indicators
of a market’s liquidity. Not all listed futures markets are actively
traded. Some are virtually dead, while others are borderline cases in
terms of trading activity. Illiquid markets should be avoided,
because the lack of an adequate order flow will mean that the trader
will often have to accept very poor trade execution prices if he wants
to get in or out of a position.

Generally speaking, markets with open interest levels below 5,000 contracts, or average daily volume levels below 1,000 contracts, should be avoided, or at least approached very cautiously. New markets will usually exhibit volume and open interest levels below these figures during their initial months (and sometimes even years!) of trading, so watch out for these. By monitoring the volume and open interest figures, a trader can determine when the market’s level of liquidity is sufficient to warrant participation.

The breakdown of volume and open interest figures by contract
month can be very useful in determining whether a specific month is
sufficiently liquid. For example, a speculater wishing to enter a long
position may prefer the futures contract with an expiration date nine
months forward, as opposed to more nearby contracts, because he believes
the forward position is relatively underpriced. The most important reservation
about trading the more distant contract would be whether its level of
trading activity was sufficient to avoid problems related to illiquidity
(poor execution prices). In this case, the breakdown of volume and open
interest figures by contract month can help the speculator decide whether
its reasonable to enter a position in the more forward contract or if
its better to restrict trading to the nearby positions.

Contract Specifications

Futures are traded for a wide variety of markets on a
number of exchanges both in the United States and abroad. Although we’ll
not provide a full list of available futures markets and their exchanges,
an example market will be provided:

Market	Exchange	Trading Hours	Contract Size	Months Traded	Price Quoted in
Wheat	CBT	9:30am – 1:15pm	5,000 bushels	H,K,N,U,Z	Cents / Bushel

(…continued)

Minimum Fluctuation	Value of min. Fluct	Max. Daily Limit	First Notice Day	Last Trading Day
1/4 cent	$12.50	20 cents(limitless spot during delivery period)	Last business day of month preceding contract month	Eighth last day of contract month

1. Exchange

The exchange is where the market is being traded. In this case we have
wheat being traded on the Chicago Board of Trade (CBT).
Among the other US futures exchanges are the Chicago Mercantile Exchange
(CME), New York Futures Exchange (NYFE) and the Financial Instruments
Exchange (FINEX) to name but a few. Foreign exchanges include the Deutsche
Terminboerse (DTB), International Petroleum Exchange of London (IPE),
Marche a Terme International de France (MATIF).

2. Trading Hours

As indicated, trading hours are listed in terms of the local times
for the given exchange (All US exchanges are currently located in either
the Eastern or Central time zones).

3. Contract Size

The specification of a uniform quantity per contract is one of the
key ways in which a futures contract is standardized. By multiplying
the contract size by the price, you can determine the dollar value of
the contract. For example, if wheat is trading at $3.00/bushel (bu.),
the contract value equals $15,000. Although there are a few important
exceptions, roughly speaking, higher per-contract dollar values will
imply a greater reward / risk level. (The concept of a contract has
no meaning in the interest rate markets).

4. Months Traded

Symbol	Month	Symbol	Month	Symbol	Month
F	January	K	May	U	September
G	February	M	June	V	October
H	March	N	July	X	November
J	April	Q	August	Z	December

The code for the monthly symbols is shown in the table above. Each
market is traded for specific months. For example, corn is traded for
March, May, July, September and December. The last trading day for a
contract will occur on a specified date in the contract month or, in
some cases, the month preceding the contract month. For most markets,
futures are listed for contract months at least one year forward from
the current date. However, trading is usually heavily concentrated in
the nearest one or two contracts.
5. Price Quoted In

Indicates the relevant unit of measure for the given market.

6 . Minimum Fluctuation

This column indicates the minimum increments in which
prices can trade. For example, the minimum fluctuation for wheat is
1/4 c/bu.. This means you can enter an order to buy December wheat at
$3.01 1/2 or $3.01 3/4, but not $3.01 5/8 per bushel.

7. Value of Minimum Fluctuation

This figure is obtained by multiplying the minimum fluctuation
by the contract size. For example, for wheat, 1/4 c/bu. x 5,000 = $12,50.

8. Maximum Daily Limit

Exchanges normally specify a maximum amount by which the
contract price can change on a given day. For example, if the December
wheat contract closed at $3.10 the previous day, and the daily price
limit is 20c/bu., wheat cannot trade above $3.30 or below $2.90. Some
markets employ formulas for increasing the daily limit of a specified
number of consecutive limit days.
This has quite a profound effect upon us as traders: In
cases in which free markets would normally seek an equilibrium price
outside the range boundaries implied by the limit, the max-limited futures
market will simply move to the limit and virtually cease to trade. For
example, if after the market close the U.S. Department of Agriculture
(USDA) releases a very bullish wheat crop production estimate, which
hypothetically would result in an immediate 30c/bu. price rise in an
unrestricted market, prices will be locked limit up (20c/bu.)
the next day. This means that the market will open and stay at the limit,
with virtually no trading taking place. The reason for the absence of
trading activity is that the limit rule restriction maintains an artificially
low price, leading to a large surplus of buy-orders at that price but
few if any sell orders.
In the case of a very sever surprise event (e.g. sudden
major crop damage), a market could move several limits in succession.
If this occurs, traders on the wrong side of a trade might not able
to liquidate their positions until the market trades freely! The
new trader should be aware of and practice caution to this possibility.
However there’s no need for overly frightened, since such events of
extreme volatility rarely come as a complete surprise. In most cases,
markets vulnerable to such volatile price action can be identified early.
Some examples of such markets would include commodities in which the
USDA is scheduled to release a major report, coffee or frozen concentrated
orange juice during their respective freeze seasons, and markets that
have exhibited recent extreme trading volatility.

9. First Notice Day

This is the first day on which a long can receive a delivery notice. First notice day presents no problem for traders holding short positions, since they are not obligated to issue a notice until after the last trading day. Furthermore, in some markets, first notice day occurs after last trading day, presenting no problem to the long either, since all remaining longs at that point presumably wish to take delivery. However, in markets in which first notice day precedes last trading day, longs who do not wish to take delivery should be sure to offset their positions in time to avoid receiving a delivery notice (Brokerage firms routinely supply their representitives with a list of these important dates). Although longs can pass on an undesired delivery notice by liquidating their position, this action will incur extra transaction costs and should be avoided.

10. Last Trading Day

This is the last day on which the positions can be offset
before delivery becomes obligatory for shorts and the acceptance of
delivery obligatory for longs. As indicated previously, the vast majority
of traders will liquidate their positions before this day.

Options vs. Other Instruments

Option trading provides many advantages over other plain stock trading. Leverage,
limited risk, insurance, profiting in bear markets, each-way betting or market going
nowhere are only a few. But let’s look at a couple in more detail.

Leverage

One thing to note before we go on is that the buyer of an options contract pays
an amount, known as the premium, to the option seller. An option seller is also
known as the writer of the option. The option premium is simply the amount paid
for the option.

When you buy an option contract from an option seller, you aren’t actually buying anything – no asset is actually transferred until the buyer chooses to exercise the optiono. It is just an agreement where the buyer has the option to decide if the transfer is to take place. But the option contracts value is determined by the underlying asset – Microsoft Shares as an example.

Options give the buyer the right to buy a number of shares of the underlying instrument
from the option seller. The amount of shares (or futures contracts) to buy is determined
by;

The number of option contracts, multiplied by the contract multiplier (also called
contract size) is different for most classes of options and is determined by each
exchange. In the US, the contract size for options on shares is 100.

This means that every 1 option contract gives buyer the right to buy 100 shares
from the option seller.

So, if you buy 10 IBM option contracts, it means that you have the right to buy
1,000 IBM shares at expiration if the price is right (10 x 100).

Note: In other countries such as Australia, the contract multiplier for stock options
is 1,000, which means the every option contract you buy entitles you to 1,000 underlying
share contracts. So pay attention to the contract specs before you begin option
trading.

This also means that the price of the option is also multiplied by the contract
multiplier. For example, say in the above you purchased 10 options contracts that
were quoted in the marketplace for 15c, then you would actually pay the seller $150.

This is a crucial concept to understand. If you go out and buy 5 IBM share options
for 15c that have a Strike Price of $25, then you will;

Pay the option seller $75

If you decide to exercise your right and buy the shares, you will have to buy 500
(5 x 100) (100 being the contract size) shares at the exercise price of $25, which
will cost you $12,500.

In this case, your initial investment of $75 has given you $12,500 exposure in the
underlying security.

Option trading is very attractive for the small investor as it gives him/her the
opportunity to trade a very large exposure whilst only outlaying a small amount
of capital.

Say you bought a $25 call option for $1 while the underlying shares were trading
at $26. If the market rallies to $27 the option must at least be worth $2 because
you can exercise your right at $25. So, even though the shares only went up 3.8%
you DOUBLED your money because you can now sell back the option for $2.

Penny stocks are also known to carry this type of risk/reward profile. Penny Stocks
are companies that have very low share prices. You can buy some stocks for as little as 10c. It is much more common for a penny stock to trade from 10c to 20c than it
is for Microsoft to trade from $25 to $50!

For this reason penny stock trading is becoming very lucrative for online speculators.
They can still trade the stocks outright as well as making massive returns if they
are correct about their view on market direction.

The only drawback with penny stocks is trying to pick which stocks to buy. I’m not
that familiar with trading penny stocks, however, I know of a great site that provides
stock picks for penny stocks every two weeks – <penny stock affiliate link>.
They have a free trial, so you can see for yourself whether penny stock trading
is for you or not.

Penny stocks can be risky though – there’s a reason why they’re so cheap, nobody
wants them! So, be careful to act on the right information.

Limited Risk

One of the biggest advantages option trading has over outright stock trading is to be able to take a view on market direction with limited risk while at the same time having unlimited profit potential. This is because option buyers have the right, not the obligation, to exercise the contract for the underlying at the exercise price. If the price is not right at the time of expiration, the buyer will forfeit his/her right and simply let the contract expire worthless. Let me give you an illustration.

Remember our initial example of Peter buying a Microsoft Call option? Here are the
details of that trade provided with the appropriate jargon;

Underlying: MSFT

Type: Call Option

Position: Long (i.e. bought the contract)

Strike Price: $25

Expiry Date: 25th May

At the time of the trade, Microsoft shares (the Underlying) were trading around
$30. The Call option contract had been valued and was trading at $6.5 – known as
the premium, but more on this under pricing.

So, from the above information we can conclude that after the 25th May, if Microsoft
is trading above $31.50 we can make a profit on this.

Why $31.50? Because we paid $6.50 for the right to have this option in the form
of a premium to the option seller. This means we must consider this in our profit
estimate. Therefore we add the option premium to the strike price to determine our
break even point.

A Profitable Trade

If Microsoft shares are trading at $40 by the 25th May, then we will elect to exercise
our right to Call the shares from the option seller. Then we will be assigned Microsoft
shares at the exercise price of $25, which is the same as if we actually bought
Microsoft shares for $25.

Note: If we exercise our right and take delivery of the shares, this means that
we will have to pay the full amount for the shares. So, the number of option contracts
bought multiplied by the contract size multiplied by the exercise price. If you
are planning to hold onto option contracts until expiry and take delivery, make
sure you have the cash!

But, they are now trading at $40 at the stock exchange! So, you have Microsoft shares
in your trading account with a purchase value of $25, yet they are trading at $40.
So, you can sell them at $40 and make $8.50 per share.

Why $8.50? Remember the premium we paid? We have to consider that with our profit
estimate.

Think about what happens as the underlying price continues to rise. You continue
to make more and more money once the stock price has exceeded the strike price.

But what about the downside risk?

A Losing Trade

Let’s imagine at expiration Microsoft shares are trading below our exercise price
of $25 at, say, $20. Will we decide to exercise our right and take delivery of the
shares and pay $25 per share? No way, because they’re only worth $20. So, we will
just do nothing and let the option contract expire worthless.

What have we lost though? We lose the premium that we paid to the seller, which
in this example was $6.5. That’s it. A lot less than if the stock plummeted and
we lost our entire investment.

What about if there is a stock market crash and Microsoft Shares are trading at
$5 at the time of expiration? The same as if the shares are trading at $20 – nothing.
We just let the option contract expire worthless and lose our premium – $6.5.

Limited Risk AND Unlimited Profit Potential

Can you see now how this type of strategy gives you the best of both worlds – both
limiting your risk and at the same time leaving you open to make unlimited profit
if the market rallies?

Not all option strategies have this payoff benefit. Only if you are buying options
can you limit your risk. For option sellers, this is the reverse – they have unlimited
risk with limited profit potential.

So, why would anybody want to sell options? Because options are a decaying asset,
which you can read more about under the Time Decay section.

Insurance

Another reason investors may use options is for portfolio insurance. Option contracts
can give the risk averse investor a method to protect his/her downside risk in the
event of a stock market crash.

Put Options

Call Options

Call options give an investor he right (but not the obligation) to buy a quantity of shares at a fixed price for the duration of the option up to date of expiration. The call option cosists of three variables:

1. The underlying stock;
2. The Expiration Date; and
3. The Strike Price.

What Are Options?

Options are one of several forms of derivative investment vehicles. That is, they are derived from an underlying investment such as property, stocks, futures etc. Here, and in all following articles, when we refer to options we will be discussing options related to shares on the stockmarket, known as Exchange Traded Options.

Put simply, an option is the right, but not the obligation, to
purchase or sell a fixed number of shares in a stock at a fixed price per share,
at any time up to a fixed date of expiration of the option. In order to obtain this
right, the option purchaser will pay what is known as the option “premium”.

We begin the explanation of options on stocks with a little story:

Lets define an option once again: An option (call) is a contract that gives the
owner the right,

but not the obligation, to purchase a security at a specified price
(strike price),

on or before a specified date (expiration date).

When trading options, the idea is to take advantage of the incredible leveraging
power of options. By making a relatively small investment in options,we can control
a much more valuable block of associated stock. In this way we receive the benefit
of the potential appreciation of that asset without owning it outright.

The expectation is that the market price of each lot will grow to $61,000 or

more, on or before a date one year in the future. $61,000 would be the break

even point,allowing enough appreciation to pay for the option. Any
increase

in price above $61,000 would be pure profit.

Each option contract controls a fixed number of shares in the underlying stock.
This number will vary depending upon which stock exhchange or country you are dealing
with. For example in Australia options listed on the ASX control parcels of 1000
shares, whereas in the US options contracts control 100 shares of the underlying.
This is something to be mindful of.

The two types of options
available: calls and puts

Margin Trading

Margin Requirements Buying shares on margin is similar to borrowing money through a margin loan to buy shares, or buying a house using a mortgage. To own a house, you are not required to have the full purchase price, only the deposit. This deposit is required by the bank to ensure that if they have to sell your house they do not lose money. CFDs offer a similar opportunity to a trader.

Most people buy shares for cash; but if you use CFDs, you can place down a deposit,
known as a margin. This margin requirement is used to protect the CFD provider if
it has to sell a trader out of a position.
The margin requirement varies from share
to share (and provider to provider) between 3% (low risk, generally the top 100
shares) and 80% (more risky shares) of the face value of the share. This is the
margin rate. For indices or currencies, margin rates can be as low as 1% of the
value of the underlying security. Margin requirements are broken into two components
known as the initial margin and the variation margin. Margin requirements
are calculated each day.

Initial Margin

Initial Margin Calculation

The initial margin is calculated on the face value of the contracts held.

Let’s say you’d like to buy AUD$10,000 worth of the Australian stock, Commonwealth
Bank, (CBA):

If the margin rate is 5%, the initial margin requirement is $10,000 x 5% = $500.

This is the amount you have to put up to enter the position (not including commission
and limited risk premium).

For short positions, the calculation is exactly the same:

If you went short $10,000 worth of share value for CBA:

Initial margin requirement is $10,000 x 5% = $500.

See the CFD QuickCalculator for easy calculations of the IM.

Notes on Initial Margin

Some CFD providers will allow you to reduce your initial margin (IM) requirement
by setting stop orders or guaranteed stop orders closer to the share price than
the margin requirement. For example, if the stop is set 2% below the current share
price, then the IM requirement becomes 2%.

Check with your provider what your margin requirements are. Although a CFD provider
will charge a higher margin rate for a more risky share, it’s important to understand
that
it is not the IM that will have the most impact on your account, but rather
the variation margin. Variation margin is explained in the next section.

Limited Risk Premium

Many CFD providers will only allow new CFD traders access to a limited risk account.
The limited risk account allows you to place a guaranteed stop with your entries.
Typically the closest this stop can be placed to the share price is 5% (in order
for the trader to take some risk himself). This is a great loss-prevention measure!
However, for this privilege you have to pay what is known as a limited risk premium
(LRP), which is calculated as a percentage of the share value of the position.

The LRP rate varies from share to share, and is based upon the share’s risk-level
(similar to the margin rate). For example, the LRP rate of CBA might be 0.3%, in
which case a position of $15,000 share value worth, will have an associated LRP
cost of $45.

Variation Margin

Variation Margin Calculation

The variation margin (VM) is your daily profit or loss on a position. It is
directly proportional to the number of shares in the CFD contract.
Let’s go back to our CBA example again. If the share price of CBA is $50, and we
have entered a $10,000 share value position, on 5% margin, then we have:

Number of shares is $10,000 / $50 = 200 shares.

Our VM will thus increase by $200 for every $1 increase in the price of the share
(for a long position), and, similarly, decrease by $200 for every $1 drop in the
price of CBA. The opposite is true for a short position.

From the above calculation, it can clearly be seen that for cheaper shares, the
VM will be higher : thus resulting in higher leverage. Care must be taken since
very high leverages can be obtained. Consider a position where the share value is
$5000 (which at 5% margin only requires $250 up-front) and the stock price $0.20.
This will result in 25,000 shares being bought. Very small changes in the share
price will have a huge effect on your account: A positive move will be highly desired
since even a slight negative move could wipe out your entire account (and more)!

The variation margin is calculated daily by a process known as marking to market.
At the end of each trading day, any gain is credited and any loss deducted from
your account. This is called free equity (a unique feature of CFDs) and allows the
trader to enjoy improved cash flow in his/her account.

Try the CFD QuickCalculator for yourself a few times to get a feel for the effect of share price and share value on variation margin (number of shares).

Free Equity

Free equity is used to refer to the free cash in your account after margin requirements have been taken into account. If you deposit $10,000 into your account and you enter
$50,000 worth of CFD positions at 10% margin, then your initial margin requirement
is $5,000, leaving free equity in your account of $5,000. If the position moves
in your favour by $500 during the trading day, then your free equity will increase
to $5,500.

Conversely, if the position moves against you by the same amount, your free equity
will decrease to $4,500. If your free equity moves to zero, you will receive what
is known as a margin call. This is a request to deposit more money into your account
or decrease the position that you are trading.

Finance Charges

Interest Charges

When trading in CFDs, you are in effect borrowing money, as you are when you place down a deposit to buy a house. There is no interest charge on positions that are
closed the same day you bought them.
However, if positions are held overnight, that
is considered longer than one day, then interest is charged, or credited if you
are in a short position.

Interest is charged or credited on the face value of the transaction, which is the
total amount of the position (share value) NOT the initial margin. In the CBA example,
interest will be charged if you are long $10,000 or credited if you are short the
position.

CFDs are like a margin loan on steroids! The leverage is much greater with CFDs
than with a margin loan. The financing structure is also different to that used
in a margin loan. For a margin loan, an investor would contribute $30,000 and borrow
up to $70,000. Interest is only charged on the money that is borrowed. If a facility
of $70,000 has been approved and the investor is using $50,000 of the margin loan
facility, then interest is charged on the $50,000 that was borrowed. If a trader
has $30,000, then this can be used as initial margin, allowing the trader to borrow
up to $1m (at 3% margin).

If $500,000 of CFDs are purchased, then interest is charged on the whole
$500,000. There is no credit given for the initial $30,000 margin that is used,
although the trader will receive interest on the free equity in his or her account.

Interest rates vary from provider to provider and are usually based on the country’s
nationally accepted rates (e.g. in Australia, the Reserve Bank of Australia, or
in the UK, LIBOR rates). They usually add/subtract a margin for long/short positions
respectively. This interest rate margin usually around 3%. So if the RBA’s rates
are 5% p.a., your CFD provider might charge you 8% for long positions held and credit
you 2% for short positions held.

Some CFD providers link their interest rates to overseas base rates.
Check with your CFD provider how interest rates are calculated. Interest will be paid on the
free equity in your account at varying rates, depending on the provider. These are
worthwhile checking with your provider.