Q&A
Don Bright of Bright Trading
ARBITRAGE
What is the difference between agency trading and market making?
Also, is it possible to arb a large-cap Canadian stock such as Nortel (NT) for price discrepancies between the New York (NYSE) and the Toronto stock exchanges (TSE), or the Nasdaq and the TSE? A lot of times, I notice that they close at different prices after you factor in the exchange rate. Would it be possible to set this up at Bright Trading? I assume you would have to access two different accounts -- one in Canadian funds that gives you professional access to the TSE, and one in US funds that has access to SuperDOT. -- C.A.V., via e-mail
Agency traders (proprietary traders) are not required to make a market in any given security, and usually trade without order flow (orders from customers). Market-making firms usually rely on their customers' orders to make money. For example, they may buy from a customer's market order at $51, and then sell to another customer's market order at $51-1/2.
Regarding your second question, many traders take advantage of certain arbitrage opportunities between markets. The more common practice involves electronic commission networks (ECNS) versus exchanges. When I trade the QQQs, I keep two windows open -- one for the AMEX, and one for Island and other ECNS. Quite often, there is a good eighth- or quarter-point profit opportunity by doing this. It is more difficult to arb using regional exchanges, since the regional specialists rely heavily on the primary market and their customer orders are few and far between.
TRADING LOW-PRICED STOCKS
You confused me and somewhat cleared things up both in the January 2001 Q&A. If you buy a $10 stock, you can buy 10 times as much as a $100 stock; 1,000 shares of a $100 stock are worth $100,000. I would never even dream of trading such a large amount! I'd be happy with $10,000 worth. But at the $100,000 level of trading, you are probably right about liquidity.
How can you talk about a 1% increase? Who cares about that? ALLR at $5.78 lost 59 cents today. That is more than 10%, and still seems of no real importance. Lots of stocks in the $10, $20, or $30 range may move $2 in a day. In other words, you are dealing with an entirely different kind of stock than Nasdaq stocks.
Please be more specific about the kind of trades and philosophy you are discussing. -- Bob, via e-mail
Sorry I confused you. Your examples speak volumes for what I was trying to explain. ALLR, for example, has traded as high as $92 and, as you know, is now around $5. The average volume for that stock is around a dismal 20,000 shares per day. The day it had its last hurrah on the downside (September 18, 2000), going down 50% or $10, it traded 160,000 shares. Stocks that have no value, and no real interest, move for all the wrong reasons.
Just because a stock moves doesn't mean you can profit from it. Say you buy something at $6. If it trades $7, that doesn't mean you can sell it at $7. You might try to sell at the market and get $5. When trading stocks that are so thin, you have to be extremely cautious about exit strategies.
In addition, check articles at www.stocktrading.com to see what concerns the regulators about executions on the Nasdaq. Another point to consider is the higher execution costs when trading more shares of a lower-priced stock.
We teach our traders to not even think about the money, only the risk. Many of our traders use $1 million or more, intraday, of my firm's capital. We monitor their actual risk very closely. We are more concerned about liquidity than price.
Most professional traders do better trading (not investing, necessarily) listed stocks where there is an actual market via the specialist system. The specialist is required to make a fair and orderly market, cannot initiate upticks or downticks, and is not trying to take your money. Market-making firms are in the business of making money from their trading, and have even bragged about how they use their customers' orders for their own gains. A specialist on the NYSE is not going to risk his or her high-dollar job by trying to cheat you out of a couple thousand shares of stock. They are subject to extreme scrutiny. But OTC versus listed is another topic.
Essentially, I want to be sure that I can always buy or sell a few thousand shares within an eighth or quarter point, not dollars. Very soon, we won't have to be concerned about any fraction, since we are converting to decimals.
MORE ON LOW-PRICED STOCKS
I don't follow your comment about low-priced stocks in the January 2001 Q&A. You said that "a major percentage move is required to make any significant money." If a stock is $5 per share and there is a 2% move up, if a trader has invested $10,000 (or 2,000 shares), he will gain 2%, or $200. If a stock is worth $100 per share and there is a 2% move up, if a trader has invested $10,000 (or 100 shares), he will gain 2%, or $200. Percentages are percentages, and the results are the same from that perspective.
It is true that low-priced stocks can be more volatile, and therefore more risky, but also they may have more potential for profit -- if you know what you are doing. Your comments about the liquidity of lower-priced stocks, however, are accurate. -- Don Kraska, via e-mail
Let me try to clarify this again. Professional traders don't invest money in each trade, and do not try for return on investment. They generally trade 2,000 shares at a time, and do not care if they are buying or selling a $5 stock or a $100 stock. Knowing that they will not have to pay any interest or hold the position very long, our traders don't think about how much money is being utilized. When you are making 20, 50, or 200 trades a day, you would go nuts if you thought about how much money is being utilized.
The traders are watching the stocks, not the money, knowing full well that they can close the trade within a quarter point (at worst) in most issues. These traders want the stock to move a half point or so, or until the market tells them to close. Therefore, they prefer the higher-priced stocks. Thanks for asking the question; I guess I was not clear.
LICENSE TO TRADE
I recently attended a seminar where people talked about daytraders who needed licenses to trade, even if they traded at home. What is the difference between licensed and unlicensed? I also spoke to people who traded NYSE, not Nasdaq. I thought all the action was on the Nasdaq. While I use many indicators like CCI, relative strength, and moving average convergence/divergence (MACD), several of the people at the seminar were against indicators like these if I wanted to daytrade, not position trade. -- G.T., Cleveland, OH
A couple of years ago, all the major exchanges started requiring professional traders to be licensed (series 7 at minimum). The firms that allow their traders to trade without licenses are simply brokers with clients. There are many restrictions to margin and market access. The fee structures are often cost-prohibitive to an active trader as well.
There is nothing wrong with using the indicators you mentioned in combination with tape reading and other tactics. The reasons our people trade the listed securities more than the Nasdaq are many, but basically it is because we are not the true professionals in the Nasdaq market; the market makers are. I often suggest that those who want to trade Nasdaq join a market-making firm such as Knight-Trimark. The OTC market is fine for investing, but we have the numbers to show that the listed market is better for our traders. (See my article elsewhere in this issue for more details about the difference between professional and retail trading.)
EDUCATION
I live in Atlanta and would like to take some trading courses. Do you know of some good ones? How about within universities? I go to Georgia Tech, but cannot find any there. Any advice would be great.
I'm also wondering why trading the S&P 500 has gained so much popularity. Do you know of a good book on the subject? What is a good way to get started learning to trade the S&P?
And what do you think of some of these systems that are advertised on the Internet? Their backtesting results are sometimes impressive. Do you know of a website that reviews these systems? -- Michael McClellan, Atlanta, GA
It so happens that my brother Bob and I are teaching a college course in Las Vegas, but I have not really seen any other trading courses. There are many finance classes, but those are always notoriously out of date. Active trading is necessary to keep up with the market. Academics generally do not, and have not, traded actively with their own money. You might see if Georgia Tech will authorize the Bright Trading internship program in Atlanta. We have credit programs at several universities and colleges. Keep your interest up; trading is a great profession!
Trading the S&P futures and their derivatives has gained a lot of popularity for several reasons. Primarily, the mergers and arbitrage houses (trading firms) use the products to hedge their stock positions, and by doing so they create liquidity in the product. Whenever there is good liquidity, there is usually room for some momentum trading. Most of the money made trading futures is made by the floor traders and the arbitrage firms. Generally, we use the futures as a primary indicator of short-term (one- to three-minute) moves in the market. We actually pay to have an audio squawk box piped into our offices.
The best way to learn how to trade the S&P futures is probably to go to the Chicago Mercantile Exchange website at www.cme.com and take the course they offer. I would prefer to do what my brother did when they listed the S&Ps on the mercantile exchange; actually trade in the pit. Many people out there claim to have a system, but, as always, be very cautious.
This brings me to your second question. I would not rely on any system -- even those that have been backtested. The problem with backtesting is that it cannot take into account current market conditions. (No letters; I know some people claim that they can.) We have never seen a system that can come close to matching what an experienced, trained trader can achieve money-wise. The most important computer is the one under your scalp!
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 March 2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2001, Technical Analysis, Inc.
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