Q&A
Confused about some aspect of trading? Professional trader Don Bright of Bright Trading (www.stocktrading.com), an equity trading corporation, answers a few of your questions. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
MARKET MECHANICS MUSINGS
You have mentioned “market mechanics” on more than one occasion. Are you referring to the actual mechanics of trading, like computer use? Or how one part of the market affects another? I would appreciate any light you can shed on this. — iowawin
You may have chatted with my traders who attended our training classes. I have focused for years on explaining how and why the markets move, both intraday and over the time of a short-term (few days, to a few weeks) trade. And yes, I can understand why you asked about the actual order entry.
Sir Isaac Newton’s words, “For every action, there is an equal and opposite reaction,” come to mind when I try to explain overall market mechanics — perhaps not always “opposite,” but maybe offset. For example, as most of us know, the futures are the leading indicators for exchange traded funds (ETFs) and equities. Since my firm focuses on ETFs and equities, we have the luxury of using the futures, second by second, for our benefit — like having a few hundred of the world’s best traders showing us the way. We have to understand the concept of “fair value,” and I can point you to my friend Hank Camp’s website (www.programtrading.com) for a definition and equation for determining fair value.
After determining fair value for the S&P emini contract, for example, we know where the e’s should be trading in a flat market, based on interest rates and days until expiration. In the real world, however, the pricing is based on supply and demand. When the floor traders we follow closely are able to sell the futures at a premium to fair value — and again, that’s based on “public paper” (go to www.tradersaudio.com for an explanation of what “paper” is versus “locals” trading) demand to buy or sell these contracts. This is where the chain reaction starts.
An easy way to see this is to watch when the underlying price changes, and the option bids and offers will also move or cancel.Say there’s a futures trader who can basically sell $1.00 for a premium, say $1.10, where the SPX underlying is parity, or that $1.00. Now this is great if they can buy back those futures immediately at a lower price. If they do not see any paper coming in to sell back those futures, then their other option is to hedge the position. A simple hedge would be to buy a basket of stocks, or the whole list of Standard & Poor’s 500 symbols. The first and most easily decipherable read we get in the equities market is from this simple understanding of this market mechanic.
Now, we can easily explain the “mechanics” of how this trade can provide an edge to our traders and you as well. Make a simple chart of the SPX (S&P 500 spot price), subtract fair value from it, and come up with the actual price of the futures (emini or big contract). You will have an immediate visual of whether these contracts are trading at a premium or a discount to where they should be trading. We’ll be able to see if when the futures are trading at a 50-cent premium, where the futures traders have gotten short and need to hedge. They hedge buying ETFs or equities. We have this “advanced look” into all this by watching the premium. We can easily buy our ETF or equity, with a higher likelihood of picking the correct direction.
Since this is such a good question and so important for traders, let me take it a couple of steps farther. If you see an option page for an equity and you see large orders at a certain price level, you can assume that the traders, both floor traders and upstairs firms, are leaning on those orders. Again, we choose not to trade options and provide capital to our traders to trade the underlying security, but when we see that large option order either being moved around or getting hit, we can logically conclude about the reaction in the equity. And of course, those who placed those option orders are more than likely hedging with the stock. An easy way to see this is to watch when the underlying price changes, and the option bids and offers will also move or cancel.
And when trading correlated pairs, still one of our most lucrative strategies, the mechanics of order entry can be as simple as having what we call a “portfolio watcher” that turns from red to green when the entry or exit price of the pair is reached. You can find out more about this at www.pairtrader.com.
So check your pricing, understand your fair value calculation, and watch and “listen” to what is going on. I hope these links I’ve given you will help as well.