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 |
PAIR TRADING WITH SPECIALISTS
Don, I enjoyed your information on pair trading. Can you elaborate on the opening moves that you have mentioned before? I have been using a similar strategy to trade the open with a specialist, but on very few stocks. It makes for good probability trades, since the specialist will open at the most favorable price (for his or her own sake as well). Does the execution system you use auto-cancel the unfilled orders after the first NYSE print, or do you have to do it manually once you receive confirmation? Do you trade/arb at all with the regionals? - Nick Kay
The strategy is simple, but the execution takes a while to learn. We enter opening-only buy and sell orders on a certain number of stocks based on fair value calculations, using an envelopeÝ around the price. We will only be filled on a few orders, and on those we are on the same side as the specialist on the NYSE (rules), and therefore have a great chance of making money when we close the trade. This basic strategy has been employed by our traders for years, with modifications.
Since we use opening-only orders, those not filled on the opening are canceled automatically. We have a few traders still trying to arb the regionals, but since many of us come from the regional exchanges and have friends on the floor, we are frightfully aware of the lack of public "paper" (customer and broker orders) involved, so the opportunities have dwindled. After the opening we roll into our pairs strategies and other sector trading.
POSTING STOPS
Do you have any sort of stop associated with your buys or shorts? Is it possible to post them with your entry? I have read in several books that you should know your exit before you enter a stock. - Bobdek
Using stop orders is tantamount to showing your poker hand to other players. "Mental" stops, on the other hand, provide a trader with the opportunity to scan the overall market conditions without being taken advantage of. Here's one prime example of something that happens every day: Assume a stock is trading 50.00/50.10 10x10. Now you see the quote: 49.00/50.10 1x1. Your (sell) stop is 49.20.
Most experienced traders actually put in buy orders as quickly as they can when they see the bid price drop, since they know that a "negotiated print" is about to take place at a lower price. Then the stock prints, say 100,000 shares at 49.10; your trigger goes off, and you lose money.
In all likelihood, the stock will rebound near its previous price, since this was simply an example of a "trade-through" aberration. Since many brokers in the crowd (and market makers at firms) are "holding orders" (so they can get extra commissions), they must rush to buy the stock at their limit prices - at which the stock goes back up - you lose. Now, if you were using mental stops, not only would you not sell, you would actually be buying and making money. Floor traders, specialists, and market makers understand this phenomenon, and use it to take advantage of stop orders and pricing variables.
SINGLE-STOCK FUTURES
What are your thoughts regarding single-stock futures and their effect/opportunities in using them for trading equities? I have to believe there will be opportunities in the beginning. One will have to lead the other. - Eugene
When the single-stock futures are listed, we will be implementing various new strategies. The obvious one will be "arbing" between the futures and the underlying based on interest rates and fair value. After that, we will explore the liquidity and depth of the markets, without which we won't be able to develop much of an edge. Adding these vehicles will lead to the elimination of the short-sale uptick rule (much talked about already), and open the doors to much better pairs and arb possibilities. Can't wait!
REVERSE CONVERSION
In an article in STOCKS & COMMODITIES, a practice called "reverse conversion" was mentioned in relation to writing options. Would you expand on this? - Adrian
A reverse conversion, or "reversal," is simply a trade where you sell puts, sell stock, and buy calls, thus doing the opposite of a conversion. Reversals are traded by floor traders who get full interest on the short-stock valuation. You sell 1,000 shares of a $100 stock, and you get interest on $100,000 minus the cost of the calls plus the receipts from the put sales. The conversion side of this (often negotiated) trade is done by off-floor traders who want long stock to sell, but who also want to maintain a neutral position. It's a "win-win" of sorts.
ON PAPER TRADING
I have received quite a few inquiries about paper trading and its benefits
in testing systems, so I thought I'd share a few thoughts. Paper-trading
results can be exceptionally deceptive for many reasons. First, you make
a gigantic assumption you are being filled at certain prices, just because
the stock traded in that range. When you start putting in orders, it can
alter the pricing of the stock. This can happen even with very small orders
(remember the straw that broke the camel's back). We encourage those testing
new strategies to try trading small, say 100 shares, to get both a feeling
for trading and a real comfort level in the results. I have had dozens
of traders come to me with pages of paper-trading results, only to find
that when they tried it out for real they lost money. I am not saying that
backtesting strategies are not viable, but paper trading can be a real
problem, as I have seen in my 20-plus years of trading, and experienced
with hundreds of traders. If you have any confidence in the methods you
are coming up with, try them small for a while - you'll be much better
off in the long run.
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 April 2002 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2002, Technical Analysis, Inc.
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