Since You Asked
| Here's something that's been too long in the planning: a question & answer column. Professional trader Don Bright of Bright Trading, an equity trading corporation, answers a few of your questions. | 
Don Bright of Bright Trading |
PAIRS TRADING
I read Stéphane Reverre's article "Pairs Trading" in the March 2001 issue, and I have a few questions. Do your traders employ this strategy? How is it best implemented? How do you pick the two stocks to trade? How do you determine which one to buy and which one to sell?
- Matt, Las Vegas
We have been employing this strategy in one form or another for
decades. We try to find two stocks in the same sector or group (such as
tech, oil services, airlines, and so on). We then overlay the two prices
back about six months to see the actual price differential. Actually, our
Redi-Plus has an indicator on price difference that charts the closing
prices for you. Based on this information, you can determine which stock
to buy and which one to short.
This is one strategy where it is actually okay to add to a losing position (we never recommend doing that under other circumstances). Let's say you sell Viacom [VIA.b] at $55 and buy AOL at $51. You have sold the pair for $4. Now, if the differential widens to $4.50, then you would sell another unit (1,000 shares or whatever increment you are comfortable with). If the differential were to narrow to $3.50, then you would take it off (that is, close the position) with a $500 profit.
There is much more to this strategy than I have space here to cover, so do your homework and keep the basics of entry and exit in mind.
COVERED CALLS
I have read a couple of books about trading options on stocks. Do you think that writing covered calls is a good way to make money? It seems so easy and simple that it makes me wonder.
- No name given
You have good reason to wonder! If you don't already own the stock,
then it is, quite frankly, silly. You buy the stock (one commission), sell
the calls (another commission), then sell the stock back (yet another commission),
and either buy the calls (that makes four commissions) or let them expire
or have the stock called (possibly more fees). You have the same risk/reward
ratio if you simply sell the put (one commission).
When I was an options market maker, we loved to do the other side of those trades because we would collect interest on the short stock and then buy the same strike price put. This is called a reverse conversion and has virtually no risk.
PREDICTING THE MARKET
On May 21, 2001, Brocade Communications Systems [BRCD] traded with
a big runup from the beginning of the day. But how do I prepare for this,
premarket or after close?
- Alojz Zadravec, via e-mailDon't I wish I knew the answer every morning before the market opens! The honest truth is, you simply cannot predict the overall market with any assurance (that's why it's called a marketplace).
On May 21 the Nasdaq market opened up and continued up all day, which is the basic reason Brcd was up. These lower-cap, relatively illiquid stocks are, by definition, highly volatile.
We have known for years that it is tough to go long on the way up or short on the way down when the share volume is so thin. Even on the runup, BRCD only traded around 180,000 shares, which works out to roughly 14,000 shares per point. That is how the market makers and the brokerage firms make so much money on these stocks, and the public (yet again) is left holding the bag. Be sure a stock trades a million shares a day or more before you attempt to short-term trade it.
One last note: I strongly suggest you do not trade preopening markets. If you think you know some bit of information, then it is certain they do. (Who is they? Whoever is letting you buy or sell stock preopening.)
SERIES 7 EXAM
Do you have any suggestions for sources of education to prepare for a Series 7 exam? Also, I have been told that some securities traded on the AMEX can be shorted without meeting the uptick rule. Could you please elaborate? Thanks for any information.
- Ben, via e-mailWe suggest two methods of study for the Series 7 examination. If you feel comfortable studying for 50 to 100 hours on your own, then you can buy books and interactive CD-Roms from several sources (search the web for "Series 7") or feel free to call Bright Trading (800 249-7488) for additional information. The CD-ROM method works well; the ones I am familiar with, such as Pass Perfect's CD-ROM, ask you the same question in several different formats. The other option is to attend a five-day cram course (this is the quickest method). Cram courses are available in most major cities. Keep an eye on your local newspaper, or ask your broker.
Regarding your second question, the AMEX trades several indices (QQQ, SPY, and others) that allow you to sell "short-exempt," which does not require an uptick. Don't try this with regular stocks! Hope this helps.
Don Bright is a principal with Bright Trading (www.stocktrading.com), a professional equity trading corporation with offices around the United States. E-mail your questions for Bright to Editor@traders.com, with the subject line directed to "Don Bright Question."
Excerpted from an article originally published in the August 2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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