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



 

PAIRS TRADING

I read your article and your Q&A section in STOCKS & COMMODITIES this month. In both, you referred to "pair trading." When I read that it was a strategy used successfully by your niece, I was intrigued. Would you please explain the strategy? - Scott Memmott

Many of our successful traders use one form or another of a "pairs" trading strategy. There has been quite a bit of research into the subject, and even an article in a previous issue of S&C. Let's start with the basic premise: Many stocks within the same or similar sectors tend to "track" one another - that is, they show correlated historical pricing. Let's take an example that we traded a year or so ago, Merck (MRK) and Lilly (LLY). Both are pharmaceutical stocks, and both are highly capitalized Standard & Poor's 500 index stocks.

If you run a simple price chart back a few years, you will see that they have crossed the same price several times. Traders can sell the higher-priced stock and buy the lower-priced one and then close the positions when they are at the same price. This is a simplified explanation of the basic concept.

Traders tend to employ overall market conditions and timing, intraday, to find a good entry point for the stock that they feel will move first. They will initiate this trade if and only if there is a bid (or offer) that they can "lean on" in the other security. Say they buy LLY when it is lower than MRK; then if LLY does not move in the direction anticipated in a short time frame, or goes against them, they will sell MRK on the bid to "hedge" themselves. At this point they have essentially "sold" the pair (since they have sold the higher-priced stock) at a given price, say $5.00.

Next, they mark that as a single trade like this: Sold LLY/MRK at $5.00. Now they will either repeat the process at maybe $5.50 (adding to the position), or cover the original at a profit, say $4.50. By trading, rather than holding, they can pull many points out of a small price range. If the pair were to trade in a channel between $4.00 and $6.00, you could trade in and out in much the same way you trade support and resistance in a single stock.

There are many more advanced variations on the strategy, but this should give you a good idea of what I am referring to. Glad to help, and keep reading the articles!


SINGLE STOCK FUTURES

Don, do you know what stocks will have single stock futures and also on which exchanges these instruments will trade? - Vinny1

As of this writing there is still some squabbling going on between the various exchanges about who will list what, who will have a primary market (if anyone), and who will get the choice issues. I think we will not see any actual trading for a few months. I am writing an article about the potential trading strategies and how single stock futures may affect both the equities markets and the index futures markets.

As I said before, there are some obvious events that will transpire, and I will touch on them, but I am trying to focus on the more interesting concepts. If we simply use the basics of dividend yields and interest rates, we see some cool plays on the horizon. When we add "basket exchanges" and pairs trading to the mix, we should see some nice techniques evolve. Stay tuned.


INTRADAY SPREADS

I have looked at chart after chart of AOL/VIA and a few other pairs I track. How exactly do you trade a spread intraday? Can you give just one example on why you took a trade? I spend a lot of time looking at how I can possibly make use of a pair relationship, and I really need just one example to link the pieces together. -Hitman

I watch AOL and VIA trade and see that the price differential has been between $3.50 and $6.80. As the pair was rising in price, nearing $6.00, I sold VIA short when I saw the overall market weakening, and repurchased it at a lower price - several times. This is the "hard" side (since you have to sell short unless you buy bullets or have a conversion), and when I wasn't able to buy VIA back (say the market reversed and the VIA spread widened to the upside), I would buy AOL, thus "selling the spread" for around $6.00.

I repeated this a few times (both the intraday selling short and covering and the adding to the overall position). I ended up with three units (at 2,000 shares each) of the spread. I sold it at $5.80, $6.31, and $6.88, if I recall. Now we reverse the logic when the differential starts to narrow. I purchased the spread that I sold for $6.88 for $6.25 and the $6.31 and $5.80 for around $5.00 or so (sure, I could've waited for a better price, but the spread could just as easily have begun to widen again). It's a very simple strategy, but it does take some time to execute properly and requires applying an envelope of buy and sell orders all day long.


FELONS

Can a felon convicted of a conspiracy charge related to drug trafficking and money laundering obtain a license to trade a proprietary account? If you do not have an answer, would you be able to direct me to someone who may know the answer or where I could research this information? Thank you. - A.K.

I passed this question to our compliance officer, and received the following response: "Anyone with any felony conviction is subject to a statutory disqualification for 10 years after the date charged. We cannot accept anyone with an SD into the LLC."
 


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."

Originally published in the March 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.



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