Q&A

I go to www.programtrading.com every day to see their fair value calculations and buy and sell programs. I have mentioned them before in STOCKS & COMMODITIES, and still think they are a good resource.

MINIMIZING RISK WITH PAIRS

When selecting a portfolio of pairs to minimize market risk, what tools do you use to minimize or diversify away the specific risk? Do you use any aspects from the capital asset pricing model (CAPM) or arbitrage pricing theory (APT)? --Alex

Excellent question. Since correlated pairs trading has been much more lucrative to those who do their homework, we have done our best to cover most of the bases when determining which specific pairs (of stocks) to trade. The CAPM comes into play, almost inadvertently, since we use "systematic risk" (beta) and "specific risk" (valuations such as price to book) in our analysis. The alternative pricing method of APT comes into play more along the lines of our historical data and spread ranges. As in most working strategies, we cannot limit ourselves to a few criteria.

Exhaustive research into each company's history, new items, take-over bids, and relationship to both the overall market and its peers is required before starting to trade any single pair. We assign a bias to each pair, based primarily on fundamentals, and trade the pair from the long side with that bias. After thorough fundamental and historical research, we look at pricing ranges, adjusted for capitalization, to determine our incremental entry and exit points.A good place to look for more pairs information is: www.pairtrader.com.

SERIES TICKER IN SPLITS

Quick options question: When a stock splits (not 2 for 1 or 1 for 2, but maybe 3 for 1 or 3 for 2), what changes in terms of the "series ticker"? That is, old strike=25, new strike=165/8, series ticker=U. I'm confused about what the series ticker is and how it changes in split situations. Any help would be appreciated. --Patrick Condon

The Options Clearing Corp. (OCC) will simply apply a new designation to the new series, regardless of the option characteristics. A simple way to find the new symbol is to go to the full option page on your datafeed and simply scroll down numerically. You can find out more information by going to www.optionsclearing.com.

CONVERSIONS, SHORT SALES, & B-LIST

I have some questions you might be able to answer for me. Regarding the shorting on a downtick rule that is now in effect for NYSE stocks, is there any difference now between a conversion and this new short sale rule that went into effect recently? Will conversions have a better chance of NXing the bid than other traders? In addition, what exactly does the "B-list" of stocks mean? According to the link, these B-list stocks are shortable on a downtick after 4:30 pm ET. Why would that matter if NYSE stocks stop trading at 4 pm, anyway? Have you gotten more positive or negative feedback from traders, especially scalpers?-Steve

Let's address these questions one at a time. The new "Sho" rules that went into effect May 2, 2005, currently affect approximately 1,000 stocks. There is an A-list (stocks that you may trade during the normal trading day with the new rules), and the B-list (stocks that are only in play after 4:15 ET).

If you have a conversion (long stock, short call, long put), then you may offer long stock at any price. If you do not have long stock, then you must mark the sell order as sell short - but the order may be filled on a downtick if it is in the A- or B-list above (subject to the time constraints, of course). NYSE stocks trade after hours as well, thus the need for a B-list.

Remember, this is just a pilot program, and we don't know if these changes will be permanent at this time.

I'm asking my traders to mark their core stocks with an "A" or a "B" to quickly determine if these lists apply. We are all gathering data to see how our stocks respond based on peers that may not be on the pilot lists. So watch your stocks and see if they respond differently by being shortable on a downtick.

OPEN ORDER QUESTIONS

I put in an SS order for a stock today and the specialist opened it at my number and then proceeded to take it north without ever going south a penny. Is this a normal tactic for an SS open order? Also, last week I had an open SS order for a stock that opened at my SS number, but I didn't get it. Again, is this a normal tactic?--Niles

If the stock opens at your number, you may not be filled since sell-short stock orders are last in line (behind sell-long orders and so on). And yes, sometimes a stock may open near where it closed, the specialist may not have to participate on the sell side, and the stock may just keep on going. Anything can happen -- we just choose to trade the high-probability plays (which the opening strategy is).

E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."