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Tharp's Thoughts Weekly Newsletter (View On-Line)

February 11, 2009 — Issue #410
  
Article

Volatility: Friend or Foe? by D.R. Barton

Trading Education

Definitive Guide to Position Sizing

Trading Tip

Mysteries of Trader Tax Status by Jim Crimmins

Melita's Corner

Farewell to our Dear Friend Melita Hunt

 

Feature

Volatility: Friend or Foe?

by
D.R. Barton

 

I’ve had some interesting discussions with folks over the past several weeks on several polarizing topics. For example, we’ve discussed whether subsidies are a good thing. In general, they’re great for those being subsidized and not so hot for those paying the subsidies. Of course, the greater good can be achieved by such government subsidies, but they can also cause undesirable effects. There are definitely two sides to the argument!

In the markets, one of the topics that produces a broad range of responses is volatility. We’ve seen marked increases in volatility across almost all trading instruments in the last six months. 

Is this a good or bad thing?

One thing is fairly certain—higher levels of volatility are most likely to stick with us for quite a while.

For some investors and traders, dealing with this increased level of volatility is tough. For long term traders and some swing traders, it’s a burr under the saddle. For others, it’s an outright menace.

Many long term investors, especially in the institutional world, equate volatility with risk. This is fairly easy to understand; higher volatility means greater variability of results. And higher variability looks like less certainty or more risk.

For swing traders, higher volatility can mean that it’s much more difficult to stay in positions. Stops are hit much more frequently and profitable positions evaporate in moments. Shorter time frames are needed, and reward-to-risk ratios tighten.

Ah, but for some, the increased volatility is the fuel that fires the engine. Intraday traders see volatility as opportunity. Wider daily ranges mean that there are more and better chances to find profitable trades.

The Best Traders’ Market

I have said many times that I believe e-mini index trading is the most potent and efficient way that a trader can employ their trading capital today, especially when using the right tools, strategies and mental approach. To understand this great trading instrument, let’s look at a little background.

In the futures trading world, e-mini index futures have grown into quite a phenomenon. They have experienced growth unlike any other instrument, and for good reason. E-mini contracts were started by the Chicago Mercantile Exchange (CME) in 1998 with the S&P 500 e-mini. Currently, it is worth 1/5 of the larger, pit traded S&P futures contract.

However, for reasons we’ll discuss next, the S&P e-mini has far eclipsed its older, higher-valued sibling. As of the first quarter of 2007, the S&P e-mini was trading 4.5 times the dollar volume of the large S&P 500 contract. Today, the e-mini trades more than 10 times the volume of the pit traded contract! There are many reasons for its popularity:

  • The e-mini contract is traded electronically on a platform called Globex. 
  • Trades are executed instantaneously and are basically error-free, especially relative to the pit traded contracts that may require several levels of human interaction before orders are executed.
  • The smaller size and therefore reduced margin requirements of the e-mini contracts allow a high degree of retail participation.

The immense popularity of the S&P e-mini has led to a number of other equity indexes trading electronically in the e-mini size. The most popular among traders are the Nasdaq Composites, Dow Industrial, the up and coming Midcap 400 and the Russell 2000. E-mini trading has also spread to commodities (e.g., gold and oil), bonds and currencies.

Let’s look at why traders love these instruments so much. After we review these attributes, we’ll talk about what’s happening now in the world of e-mini trading.

Leverage. One of the biggest advantages for e-mini trading is the high amount of leverage they offer. And for day traders, this leverage is increased further. Let’s look at the actual leverage available: the S&P e-mini trade unit is $50 times the S&P 500 Stock Index. Currently, that calculation looks like this: $50 x 830 = $41,500. The margin to control $42k worth of stock is around $6k, giving you leverage of about 7:1 on your money. However, the day trading margins drop significantly with $1,000 margins still available and some reputable firms offer $500 margins. At these rates, you can increase your intraday margin to greater than 80:1!

But leverage is a double-edged sword that definitely cuts both ways. While such leverage allows for large returns on very little money, it can also mean that you can lose large amounts as well. In next week’s article, we’ll cover tools that allow us to use this leverage in a big way, while protecting our downside.

Liquidity. Liquidity is usually thought of in terms of volume, and it is this characteristic that gives us the ability to get in out of trades quickly and at a preferable price. E-mini index trading gives us exceptional liquidity and great fills with little slippage. These attributes are necessary to allow us to take advantage of the available leverage.

Scalability. Certain types of trading can only be used on a small scale and cannot be translated to larger volumes as success occurs and larger position sizes are required. But e-mini index trading in general and S&P e-mini trading in particular are highly scalable. Getting virtually no-slippage fills on 200 S&P e-mini contracts is an extreme advantage.

Round-the-clock liquidity. The S&P e-mini has liquidity 23.5 hours a day, which gives another advantage—the effect of overnight gaps is greatly reduced. You can keep a stop in the market if you’re doing a swing trade and have your protection kick in at a time when your IBM stock is still sleeping.

The Best Market Keeps Getting Better

As I mentioned above, higher volatility equates to greater opportunity for day traders. And today’s markets are giving us unprecedented levels of volatility. Since June of 2008, we have had ZERO days where the Average True Range (ATR) for the 24 hour S&P 500 e-mini contract has been below 20 points! Combined with the leverage available in the e-mini markets, we have a place where every trader can compete with a level playing field and find multiple opportunities every day.

Next week, we’ll look at some specific tools and strategies that top e-mini traders are using today to take profits in these markets.

Please note that I’ll be teaching a new, cutting edge workshop on e-mini index trading in Raleigh on March 14–16. Next week I’ll tell you about my good friend and awesome market maven who will be joining us for the workshop. It’s a learning experience you don’t want to miss!

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”.  

 

Trading Education

DEFINITIVE GUIDE TO POSITION SIZING

Because Size Really Does Matter in the Markets, 

Van Tharp's Definitive Guide to Position Sizing

Position sizing is that portion of your trading system that tells you “how many” or “how much.”  How many units of your investment should you put on at a given time? How much risk should you be willing to take? Aside from your personal psychological issues, this is the most critical concept you need to tackle as a trader or investor.

BUY NOW  or  Learn More

Trading Tip

Mysteries of Trader Tax Status

by
Jim Crimmins

Just because you call yourself a securities trader doesn’t make you one in the eyes of the Internal Revenue Service.

In fact, Uncle Sam is predisposed to consider you merely a hyperactive investor—and thus deny you more favorable tax status—unless you meet a number of criteria that are frustratingly open to interpretation.

You read that right: the tax code contains no actual definition of trader tax status.

Instead, the IRS has issued guidelines that the tax courts have expanded upon with case law, most of which denied tax appeals by traders.

What we’re left with is a blurred image, like a photograph of a trader taken from a speeding car.

According to the IRS, to qualify as a trader:

  • You must seek to profit from daily market movements in the prices of securities and not from dividends, interest or capital appreciation;

  • Your activity must be substantial, and

  • You must carry on the activity with continuity and regularity.

To help determine if you meet these three tests, the IRS considers these qualifiers:

  • Typical holding periods for securities bought and sold;

  • Frequency and dollar amount of trades during the year;

  • Extent to which you pursue trading to produce income for a livelihood, and

  • Amount of time you devote to the activity.

Swoosh, right? What is “substantial” activity? “Continuity and regularity?” And what’s an acceptable holding period? Is a week too long? A month?

We know who investors are: They’re our hardworking neighbors who buy securities and hold them for such long-term goals as a college fund or retirement.

Traders, on the other hand, buy and sell securities solely to take advantage of short-term market changes. Your profits come from price swings, not dividends and interests. Since your holding period is brief, often a day at most—hence the term “day trader”—there’s no need to perform due diligence on the companies you trade.

Who cares how the IRS classifies you? You do!

Investors are subject to the 2% threshold for deductible investment expenses—and hence cannot write off most of their expenses—and are limited to a $3,000 capital loss deduction.

But as a trader, you write off 100% of your expenses, and if you elect the mark-to-market accounting option, you can offset all of your losses against income.

Three Steps to Claim and Protect Your Trader Tax Status

Step 1: Prove beyond doubt that you are a bona fide trader—that is, you “seek to profit from daily market movements.”

The best way to accomplish this is by showing a pattern of high trading volume and short holding periods. Keep your personal investments well separated from your trading business. The IRS is looking for “earnest intent;” that is, you work diligently to manage transactions, conduct strategy sessions and make frequent trades. 

Step 2: Clear the “substantial activity” hurdle.

The hallmarks the feds are looking for here are “frequent, regular and continuous” trading. That means volume. One court case ruled that 75 trades a year was insufficient to warrant trader status. The feds need to know that you approach this as a business, not a hobby. Fail to convince them of that and you’re back in investor-land.

Step 3: Trade with “continuity and regularity.”

If you want trader tax treatment, it only stands to reason that you must actually be in—and remain in—the business of trading.

Here’s where the IRS is looking for a healthy flow of trades, significant dollar amounts, short holding periods—all the signs that you are at least attempting to make a living as a trader.

If you take the summer off or show other gaps in your trading, the IRS will be disinclined to grant you trader status. If you’re a newbie and flame out after nine months, while it seems unfair, the IRS has made it clear: no trader status for you.

Once you obtain trader tax status, you’re not entirely in the clear. Owing to the capricious nature of appellate rulings and the ever-evolving tax code, there are no guarantees that the trader status you enjoy today might not be gone tomorrow.

One good way to secure your trader status is to trade under the umbrella of a business. That’s not only where the most lucrative tax advantages reside, but a legal entity such as a general partnership, Limited Liability Company or C corporation sends a strong message to the IRS that yours is an earnest and legitimate business enterprise worthy of trader tax status.

Cheers,

Jim Crimmins

About Jim Crimmins: Jim has become a nationally known speaker on tax strategies, entity structuring, and lifestyle change. He delivers over 30 talks a year throughout America as well as speaking in several chat rooms each month.  You can learn more at TradersAccounting.com.

IITM Third Party Clause

Melita's Inspirational Corner

Farewell to our Dear Friend Melita Hunt
Former CEO of the Van Tharp Institute

After a long and courageous journey with stage four lung cancer, Melita Hunt has passed away at the age of 41. 

She was truly a remarkable person. She was a bold leader, intelligent business woman, inspiring writer, world traveler, and much much more. For a such a petite person, Melita was a huge life-force. When she walked into a room, the room lit up.  

We have stories pouring in from all corners of the world from people who may have only met her once but recall the positive impact she had on them in such a short period of time. Those of us who did know her well, know that she was a positive influence all the time. She always held each person in high regard and expected everyone to do the same for themselves. She believed in being honest and openly saying what she felt, and she was able to do both without passing judgments. Her ability to see the best in people never failed. 

We will miss her immeasurably. We will remain forever inspired by the life she lived and the love she gave so generously.

Over the next week we'll add information to her blog for those who would like to make a donation in her memory (her family has requested that instead of flowers), and more information about how we'll celebrate her life in Raleigh, NC. Visit her blog, www.myleftlung.com for more information. We encourage you to add comments to her blog. Both friends and family love hearing from all the people Melita managed to affect over her short lifetime. 

We've put together a few photos of Melita. If you'd like to see them, click here. 

 

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Copyright 2009 the International Institute of Trading Mastery, Inc.

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Tharp Concepts Explained...

 

- Psychology of Trading

- System Development

- Risk and R-Multiples

- Position Sizing

- Expectancy

- Business Planning

Learn the concepts...

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Free Downloads

Handbook for Traders and Investors

 

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Free Trading Simulation Game

A computerized version of Van's famous "marble game."

It is designed to teach you the important principles of proper position sizing.

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