Since You Asked
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.
Don Bright of Bright Trading
PRACTICAL ADVICE FOR NEW OPTIONS TRADERS
I recently started to look at options trading and am considering LEAPs in particular. As with everything else, I'm learning that “the devil is in the details”; we might have a general understanding of things, but actually getting into the market is a different matter altogether.
Can you give me practical advice on what to do to trade options? I would greatly appreciate it if you could give me some pointers on what dangers I should expect, such as not getting my position filled by a broker.-Jamie
First, you need to learn the valuation principles of conversions and reverse conversions; they tend to trade at or near a fair value based on interest rates, dividends, and days until expiration. Don't get swayed by over - or undervalued calls or puts when compared to simple historical volatility.
Floor traders, along with the major firms, are among the most savvy traders on the planet - and they have the best overall tools. They have the ability to “cross-instrument” hedge at all times (that is, lay off interest risk via currency variables, and so on), as well as “cross-market” hedge with the equity futures (such as a basket of stocks/options and futures).
Options are mostly used by those who don't have the capital to trade the underlying security (retail customers who want limited risk by buying time premium in the calls or puts). Professional option traders are always looking to either sell time premium or collect short stock interest on reverse conversions (buy call, sell put, sell stock, thus collecting interest on the short stock dollars). Retail customers, for the most part, are not able to collect interest on their short stock cash.
After you understand these basics, feel free to ask more detailed questions. We can get into spreads, straddles, strangles, synthetics, and all the rest.
LIMIT ORDERS VS. MARKET ORDERS
I always look forward to your column in S&C, and was hoping you could help me. I heard you say at a presentation that you always use limit orders, especially if you want to get in or out of a trade very quickly. I was told to use market orders by my brokerage firm, and they charge extra for orders with price limits. This is confusing. Can you shed some light on what I should use? - Charles
You are in the same quagmire as most traders who trade in a retail trading account. Generally, the good rates/commissions that are offered only apply to market orders (with no limit on price). First off, you must realize that your orders go through your brokerage firm, where they can choose to trade against you, sell the order to a third party, or send it on to the NYSE or an electronic communications network (ECN). Imagine yourself in their position: You get a market buy and a market sell on the same stock at the same time. You might be tempted to buy low and sell high (buying on the bid, selling to the other customer on the offer), right? For years, this practice allowed for all of those low-commission rates to be offset by pricing profits, and for many brokerage houses, it still happens. It doesn't do much good to save a couple of dollars on commissions if you lose $100 on slippage.
Now to why I teach my traders to use limit orders. Our orders go directly to the NYSE (except for a few that go via ECN) on the DOT system (direct order turnaround), and don't have to stop at a brokerage firm. This electronic system allows the assistant specialist on the NYSE to fill the limit orders immediately, with whatever the best current bid/offer is. Market orders are usually batched and held by the specialist for a few seconds, which may mean price movements in the stock have taken place. We often enter buy orders above the offering price and sell orders below the bid price, knowing full well that we will get price improvement. This allows for a quicker execution, and you still get the better price.
SERIES 7 REQUIREMENTS
Recently, I noticed on your website that a Series 7 license is required to trade with your firm. Could you explain why? I have traded my own account for three years now, and I don't have a license. - Mary B.
When I started trading back in 1979, I thought it was great that I could join a stock exchange, deposit a small amount of money with a clearing firm, and trade with their money (and get to keep all the profits). Even with only $25,000 or so at risk, I could use $1 million or more of the exchange's money for my own trading. Bright Trading started offering this same business model about 15 years ago for those who wanted to trade for a living. As an added extra benefit, traders didn't have to buy a membership on an exchange, since we did that for them.
Our number of traders grew, as did the trading industry during the 1990s, and they enjoyed the benefits of using our capital and market access. Around 1998, there was some turmoil, and regulators decided that they had to make a distinction between professional and retail customer traders. They asked those who trade professionally and use the offered perks to pass the registered representative exam (Series 7). Since then, we have asked our people to take the exam. It's a small price to pay for the benefits received by those who want to trade for a living.
E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."
Originally published in the June 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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