The standard protection used by traders is the stop loss.
Most traders have a real love-hate relationship with their stop losses.
Of course, we must protect our trades in the markets … but, boy, do we hate it when they get knocked!
And we hate it even more when our trades are just touched out, only for the markets to turn back in our favour.
It has to be the biggest grumble traders have.
Over recent weeks I’ve been looking at ways to avoid this happening, including some alternatives to the stop loss.
The most straightforward alternative, which we’ve covered at length in Market Maven, is to use binary bets. These can’t be stopped out by sudden market swings, and they offer traders the security of a fixed risk.
I’ve been mightily impressed by Neil Leitch’s Beat the Binaries trading strategy, which has already been showered with praise by many users. If you’ve not tried it out yet, it’s still available .
But, of course, binary bets aren’t the only solution.
Another, more progressive approach is to use arbitrage – and I’ll be talking a lot more about this in the New Year.
Arbitrage has a reputation for being a top-end trading solution for the likes of hedge-fund managers.
But the key thing to note about financial arbitrage is that in its purest form, it’s risk-free trading.
That’s right: risk free.
How’s that for a holy grail?
Unfortunately, the rarified air of pure risk-free arbitrage is only available to those with the kind of market access and deep pockets that financial institutions have.
But how does “almost” risk-free sound?
Well, it sounded pretty good to me, which is why I thought I’d dig a little deeper into the arbitrage story.
What is arbitrage?
Arbitrage is essentially the process of buying something at one price in one market, selling the same thing at another price in a different market, and pocketing the difference.
A bit like buying something cheap at a car-boot sale, and selling it for more on Ebay.
The financial arbitrageur will scour the markets for tiny price discrepancies between two markets (like stocks and futures for the same stock), so that he or she can take advantage of the difference. And the security of this type of trading comes with being long and short in the same market at the same time.
The markets can go up or down – it doesn’t affect the arbitrageur. For example, if they’ve bought Stock X, and sold futures of Stock X, then the value of that stock plummets – it doesn’t matter, because they’ll win on one trade what they’ve lost on the other. All they care about is the price anomaly that they are taking advantage of.
This type of insurance policy is called hedging. Some traders hedge purely for protection. But the arbitrageur hedges and uses it to profit.
How do we get started?
So, if it’s that easy, low-risk and profitable – why aren’t we all doing it?
Well, the problem with arbitrage is finding these discrepancies. Plus, the differences tend to be small, so you need big money to make it work. Plus, you need to be confident that you can get high-speed dealing so that you can buy and sell at the same time.
With individual stocks and shares, there can be problems with liquidity – and you don’t want to get stuck with shares while they are falling.
So for private investors, arbitrage would need to be practiced in a bigger, safer marketplace.
A trading technique I’ve been using for a few weeks now does exactly this. So far the results have been promising, as is the feedback I’m hearing from traders who’ve tried it out – I hope to bring you a full report soon.