Designing a Trading System: What Should You Trade

By Michael J. Carr, CMT

Designing a trading system is simply a series of decisions. First is deciding what edge you have over all the other players in the market. This isn’t as difficult as it sounds. Using a logical approach to the markets, any individual can develop a unique insight that lets them profit. This is easier when you consider all of the available markets you can trade and discover which one best meets your needs.

Many traders make a default decision to trade stocks, simply because that is all they know. Stock markets are widely covered in the news, and changes in Dow Jones Industrial Average or S&P 500 Index are in the headlines almost every day. For more than a decade, online brokers have advertised their low commission rates on television, and everyone has heard of that lucky guy who day trades from his living room and wears his pajamas to work.

Stocks may be the best choice, especially if you are willing to accept relatively low returns. In the long-term, meaning over the past two hundred years, it is well documented that stocks deliver an average return of 8-10% a year. That would mean you could expect to earn about $10,000 on a $100,000 trading account, on average. This is not the kind of money people dream about when they consider trading for a living, and many traders start with less than $100,000.

Adding to the problem of relatively small average gains is the issue of the variability of returns. In any single year, the stock market averages may end with a large gain or a large loss, or could even end up right about where they started. About 95% of the time, returns fall between a loss of 25% and a gain of 40%. New traders should realistically understand they will have a tough time beating the market if they are just trading stocks part-time. Given the uneven returns, the risk of losing years, and the fact that most traders start with modest amounts of trading capital, we need to think about ideas that offer larger returns than the stock market.

One way to boost potential returns is to use margin in your account. You can borrow half the money for an investment from your broker, and at discount brokers the interest rates are usually fairly low. If you have $100,000 to start trading with, full margin would you allow you to by $200,000 worth of stock. A 10% gain would give you profits of $20,000. Losses are similarly magnified with margin, and a $20,000 loss would represent 20% of your trading capital.

Day traders are able to use a greater degree of leverage. Most brokers will let you trade $4 for each $1 you have in your account, but you can’t hold these positions overnight. Now that $100,000 account has the potential to deliver $40,000 on a 10% gain, if you have the ability to be a winning day trader. We’re dealing with realistic assumptions, and the truth is most beginning traders can’t quit their day jobs when they start trading.

Small amounts of capital and big dreams often lead traders to consider options contracts as the key to riches. An option contract gives you the right to buy or sell 100 shares of a stock for a predetermined price at some date in the future. Calls are used when you are bullish and want the right to buy the stock in the future. As is often the case, an example may help clarify this. You may think that the S&P 500 should be trading at 1400 by the end of summer. An exchange traded fund, the SPDR S&P 500 (SPY), tracks this index and one share sells for 10% of the price of the index. If SPY is trading at 126, you have a potential return of 10% on your investment. One hundred shares will cost $12,600, but a call option allowing you to buy 100 shares of SPY at 135 expiring in mid-August would only cost about $100. If you’re right, you’d make $5 a share, or $500 on your $100 investment.

Put options allow you to sell 100 shares of the stock at a preset price for a certain amount of time. This tool lets you make money in a down market. Like calls, great profits from small investments are possible if you’re right. However, a lot of studies have shown that option traders lose more often than they win. Pricing of the option is determined by a lot of factors. Most important is the probability that the price will reach the predetermined level over the timeframe defined in the contract. A second critical input to pricing formulas is the current interest rate. Individuals would need to dedicate a lot of time to studying the pricing models to successfully compete in this market, and few have the time, or the math skills, to become experts. There are some who can trade options well, but most beginning traders should be very careful and plan on dedicating a great deal of time to the markets if they want to trade options.

Futures are often thought of as risky, and many traders have heard stories of someone who failed to close a trade and ended up with a truckload of soybeans being dumped in their front yard. Risk is a big part of futures trading, but most brokers will automatically close your position long before you get an unexpected delivery. Futures contracts represent a commitment to buy or sell at a date in the future, at whatever the market price is at that time. Most contracts for financial futures like Treasury bonds or stock indexes, are settled for cash, eliminating the need to actually own anything. Those contracts that do involve physical commodities, like sugar or coffee, will usually be sold by the broker prior to expiration to prevent accidental delivery. But, you’d want to take profits or cut your losses anyway so you’d enter a closing trade before that happened anyway.

Futures require a small amount of margin, generally less than 5% of the contract value. You could trade 100 ounces of gold for about $7,500, or for about $3,000 you could trade $100,000 worth of Treasury bonds. The potential gains from futures are large, because this leverage allows you to get the most bang for your investment buck. With a $10,000 account, you could trade several commodities with underlying values of $150,000 or more. Returns are based on those underlying values, and annual gains of even 10-20% on that amount make it possible for the small trader to quickly reach the level where they can earn a living. Managing the risk in futures trading can be built into the trading system, and while success can’t be guaranteed, catastrophic losses can certainly be avoided.

Options are also available on futures contracts. The pricing of these investments is difficult to understand since you are actually buying a derivative of a derivative. There is also very little volume on most of these contracts which leads to dramatically higher trading costs. Options on futures can be used effectively as part of complex trading strategies, but it is very unlikely that a new trader will be able to use them profitably as the investment of choice. Again, the low price of options contracts may look appealing, but no one should trade them without spending a great deal of time learning about what the investment really is.

Foreign exchange is a highly leveraged investment like futures. Some brokers will allow you to invest $300 or more for each dollar in your account. Limiting the investment total to 20 times the value of your trading capital can deliver large enough gains to help you eventually make a living from trading in this market. This is a highly liquid market, with trading volume estimated at $4 trillion a day by the Bank for International Settlements. You buy and sell currency, like US Dollars or Japanese Yen, in this market. Volatility is fairly high at times, and that creates opportunities for quick trades that add up to real money. Minimum account sizes of several hundred dollars are available at several brokers, and a few thousand dollars allow small traders to build a diversified portfolio.

Deciding what to trade is as important a decision as deciding how to trade. Small traders need some degree of leverage to generate significant profits. Stocks, without margin, offer a low risk way to learn the mechanics of trading, including things like how to place orders which is actually a skill that needs to be learned. But to actually make a living from trading, futures or foreign exchange might be the right choice. Risk can be managed, when it is understood. With a little effort and a proven trading system, leverage allows small traders to earn big profits.