Q&A
Since You Asked
| Professional trader Don Bright of Bright Trading, an equity trading corporation, answers a few of your questions. | 
Don Bright of Bright Trading |
INDEX ARBITRAGE
Don, I have enjoyed your commentaries in STOCKS & COMMODITIES. Can an individual buy a "basket" of stocks economically enough (say with your firm) in order to perform index arbitrage: selling futures versus buying cash and vice versa? "Spread trading" or hedged strategies appeal to me; what valid spreads do you teach or trust, and can an individual perform S&P or E-mini arbing almost as effectively as the floor traders or market making firms? Thank you.
- David Pfizenmaier
You've brought up a couple of interesting ideas about arbitrage methodology. If your costs are low enough as you mentioned (trading with a proprietary firm), then you can do very well trading baskets of individual stocks vs. a futures contract. With point-and-click trading and by using links to the exchanges or electronic communications networks (ECNs), a trader can almost simultaneously execute orders upon finding a discrepancy in pricing. That covers the tactical aspect of performing the functions necessary.
Now for the strategic aspect of these methods. Hedge baskets can range from a handful of high-cap stocks to the entire Standard & Poor's 500, for example. A good arb trader will find a proper sampling that will reflect the larger index, but this is not easy. You will find that oftentimes adjustments are needed based on news items, earnings warnings, and so on. Our traders don't generally hedge with the futures, preferring to use them instead as immediate indicators to tell which side of the pair trade or spread trade they want to open first. Thanks for reading the column, and thanks for the kind words!
COMING SOON
I have been told there are new margin rules and requirements for active traders. Can you explain the differences?
- Leon T. Phoenix
I will be doing a complete review of the major changes in the regulations for active traders in the very near future. Since there are several compliance issues involved, I want to wait for some clarification before publishing my review. By next month I should have a good handle on the whole thing. I have read conflicting stories already, and don't want to fall into the trap of giving misleading or slanted information. I did note there is a "self-policing" aspect to the new rules that should prove interesting. Please check back next month.
EXAGGERATED ADVERTISING
I have been reading your column for some time now, and notice you seem to be forthright when it comes to your opinion on trading programs and software and the like. I recently saw an ad for spread trading on TV, and the ad made it sound great. It showed an example of a company that is about to make an earnings announcement, and the system shows you how to make money whether the stock goes up or down. The example showed the company putting out an earnings warning rather than good earnings, and they claimed to make a large profit from the stock price decline. Is any of this possible?
- J. Pack, Grass Valley, CA
Don't get me started! I did see (what I am pretty sure is) the same infomercial. They claim "limited risk" and large potential profits from a stock move. I thought it was humorous they used the same sales tactics as the people selling knives and other household products ("Buy within the next 30 minutes and receive this book and that CD for no additional cost!").
I am pretty sure their tactic is something as mundane as buying option straddles (buying both a call and a put of the same strike price on the same underlying security), or strangles (buying calls and puts at different strike prices on the same security), with the hope the stock price will move significantly. As with any option purchase strategy, the buyer is limited to only losing everything they invested in the options. And, yes, they can profit from a significant move in the stock price (obviously, if you can read the future you can make money!). What I find in all of these option "secrets" is they fail to inform the consumer that the option market makers are expert traders and will price the calls and puts based on anticipated stock movements. This generally prevents most option buyers from making money, and usually leads to significant losses from the time decay in price. Since most of the money being made in options is from their sale, not their purchase, you must assume some risk to better your chances of profit.
Thanks for reading the column, and for helping to make others aware of potential pitfalls.
RATES WITH BLACK-SCHOLES
Can anyone tell me what rate to use and for what time period in calculating the value of warrants (using the Black-Scholes model) with expiration dates that don't match any of the US government securities maturities? For example, what rate would I use for a warrant that expires two years and five months from the valuation date? Thanks.
- eebarn@about.com
The Black-Scholes model allows for the difference between "long" money and "short" money (whether you are finding uses for excess cash in the bank, or borrowing money to take advantage of a current market condition). I suggest you figure out your current position, and either add or subtract half of 1% to cover your costs. Then use the actual number of days to determine your daily premium decline. In addition to interest rates in Black-Scholes, you need to consider the historical volatility of the underlying security, and the current implied volatility to see if the pricing is at/over/under fair value. Hope this helps.
Don Bright is with Bright Trading (www.stocktrading.com), a professional equity corporation with offices around the US. E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."
From an article originally published in the November 2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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