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//***************** Leverage and Funds - October 1st, 2019 ******************//
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- Okay, let's repeat some announcements:
- You have a project due this weekend - make sure to start it!
- NEXT WEEK, we'll have our 1st exam on October 10th - the exam will be ALL multiple choice/true and false
- A quiz on Canvas worth 1% of your grade will be posted as a practice exam
- The quiz will be 10 questions; the actual exam will be 30 questions, and should mostly be "remember this or don't" style questions
- "There's absolutely nothing stopping you from cheating on this quiz, but it's only worth 1% of your grade, so..."
- "I prefer short-answer questions, but with 300+ students my TAs would murder me, so..."
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- Now, let's get back to leverage!
- Leverage is basically how much your broker lets you invest money you don't have, which is calculated as your "money at risk" divided by your account's current liquidation value
- If your leverage is 1.0, then you are "fully leveraged;" if your leverage is greater than 1.0, that means your BROKER's money is at risk
- This calculation might seem simple - too simple, even - because it IS too simple!
- These values can change as time passes, which makes calculating leverage a LOT more complicated
- Right now, it seems like you can't have negative leverage, but it IS possible because you can have changing stock prices!
- Assume you deposit $1 an then invest $10,000 in some stock, meaning you have 10,000 to 1 leverage
- No sane broker would let you do this, but some foreign exchanges allow similar stuff since they're not regulated
- This is SUPER risky; brokers are infamous for something called "running the STOPs," where when brokers see the currency is about to turn around, they'll buy a bunch of stuff to change the currency value, triggering their own customers stock sales, which then turns the currency the other way and makes them money
- "This is super interesting wild-west stuff, but it's SO easy to get screwed"
- Let's suppose the stock price then drops by 50%, meaning you now only have $5000 of value
- That means your leverage is "5000 / (5000 - 9999)," which means you've got a leverage of ~-1
- If the stock further drops, then your leverage will technically increase (as in, becoming less negative)
- This would be WEIRD for your broker to deal with, but fortunately for them, they'll stop you before your leverage gets higher than ~5 or so, so it'll never practically happen
- Now, if your leverage ever gets too high, you get a very unfun thing called a MARGIN CALL
- This is basically a letter that says "Hi, we're your broker; we agreed your leverage couldn't be higher than 3.0, but due to movements in the stock market your current leverage is 4.0. You have until the end of tomorrow to get it below 3.0, or we'll do it for you by closing your positions without your say."
- Needless to say, you don't want your broker to sell your stuff at random times; pretty much by definition, margin calls happen when your portfolio is losing value, so it'll mean you sell stuff at a loss
- If it had been your own money, you can just wait out the rough patch and still have some hope of the stock recovering
- Now, do brokers always order on the exchange? That's easy: no!
- Suppose you've got 3 exchanges: the NYSE, NASDAQ, and BATS (which tried to fix a problem with NASDAQ where people would pay to get their router physically closer to the exchange's, so they'd have a several millisecond head-start)
- You could tell your broker which exchange you want to trade on, or just say "I want this stock, get it on the best available option"
- The problem, though, is that your broker knows the exchange requires fees to trade on
- So, brokers will first try to INTERNALIZE the order by swapping your buy/sell stock with another customer that's trying to sell/buy stuff
- This typically saves your broker money, and can also give you some net savings, too (although they'll usually just pocket the difference)
- Brokers realized this was good, and so multiple broker groups started to do internal trades with each other, known as DARK POOLS
- The vendors actually make money running this, since they're allowed to look at those orders and say "that's a good order, I'm going to use that myself!"
- In order for this to be legal, dark pools have to give you at LEAST as good of a deal as on an actual exchange, so they can't screw you out of money
- So, brokers will try to handle your order internally first, then go to the dark pools, and then finally trade on the exchange as a last-resort
- No matter where you make the trade, the exchanges still have to get notifications that stock has been traded
- We seem to keep assuming that prices are the same across exchanges, countries, and so on - why?
- The big reason is ARBITRAGE: a low-risk trading strategy where we find and eliminate price deviations between prices that should be the same
- This technically originates from silk road-era trading: if you notice cinnamon is cheap in India and expensive in London, that's geographic arbitrage! You go to India, buy cheap, and sell high!
- GEOGRAPHIC ARBITRAGE these days is literally using high-speed connections between different exchanges to identify miniscule price deviations between different stocks/stuff, and then buying the cheaper one and selling the expensive one
- This is a SLOW way to make money, but very low-risk
- LATENCY ARBITRAGE is a classic high-speed trading strategy where fast connections literally see prices faster than other people. The process looks like this:
- The order book is in state S at time T
- Trader sees the book S at T + 300ns and wants to buy it
- Buy order is received at time T + 600ns (since the trader saw a lot of demand)
- You, in Seattle, see the book's original state S at T + 12ms, and you make the same buy decision as the trader
- Your buy order is received at T + 24ms - but the price has already gone up!
- After all of these delayed buys came in, the stock price has gone up a little bit; the trader then sells the stock to make a bit of money
- This is kind of like insider trading, but legal, because the order book is "public" when the trader receives it
- Some people have proposed doing an auction-style system to resolve this, where the best price is used for orders within the last second, but this hasn't taken effect yet
- Alright; with 10 minute left, let's get into the next topic: FUNDS!
- What are these? Legally, an INVESTMENT FUND is a group of people/companies that pool their cash to make investments
- Why would you invest in these? 2 main reasons: scale and diversity
- DIVERSITY is (as we'll show later) good for reliable returns, but unless you're super-rich you don't have enough money to buy diverse stocks, and it's a management pain to keep track of each stock, rebalance the portfolio as prices change, etc.
- Instead, if you pass that management burden over to the fund, it'll handle it for you and let you buy a basket of stocks
- There are 3 main types of funds we'll focus on here:
- EXCHANGE TRADED FUNDS (ETFs) trade like a stock on an exchange, and can be bought and sold
- These are usually the simplest funds and are based off of a formula, meaning they can be updated automatically
- This is good if someone says "the market is going to overall go up/down" and doesn't care about a particular stock
- MUTUAL FUNDS only trade once a day and aren't listed on any exchange
- Instead, someone sits down and calculates how much each share of the mutual fund is worth, and the fund is then bought/sold at this price
- The stocks in these are hand-chosen by "skilled" investors, and are usually focused on longer term investments
- HEDGE FUNDS are like a more private version of mutual funds, and you're legally not allowed to buy them unless you're rich
- The big difference is that hedge funds are allowed to short stocks, and can invest in ANYTHING (not just stocks in bonds)
- This means you can get a lot of return from them, but it means they can get absolutely wrecked at times (*cough* 2008 *cough*)
- Alright, come Thursday to continue this discussion!