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 |
LOW-RISK PAIRS TRADING
You've spoken of pairs trading with praise, and I think you have a group of traders engaging in this strategy. Can you suggest a way to start trading this market-neutral strategy without risking too much money (I have a small retail account at this point)?- jackeeo
Absolutely! For those who haven't heard much about "correlated pairs trading," feel free to check my website (www.stocktrading.com) and then click on the PairCo link.
When traders are just starting out, we suggest something called "crutch" pairs trading. First, do a bit of research to find two stocks in the same sector, with similar capitalization and (especially) similar current prices. Check an overlay chart with both stocks to see how well they have tracked for the last few months, and even the last few years (look back 10 years if possible). Generally, we initially choose the most fundamentally strong stock as the "lead" stock (the likely long position), with the weaker stock as the likely short position.
Let's use the GE/HON pair as an example. Let's assume that if we were to take a long-term position, we would want to be long HON, and short GE (based on price-to-book numbers). Over the last couple of years, their relative prices have crossed each other several times and the spread range ran between $1.00 and $5.00 for quite some time. Recently, HON has outperformed GE considerably, showing the longer-term reason for preferring to be long HON.
Now, for initial trading, try this: short GE on a flat day, and do nothing with HON at first. If GE goes down, simply cover with a profit. If GE heads up, buy the HON from the offer you were "leaning" on. Only do this if the current price differential is in a place that makes sense based on your historical research.
What you've done is save on commissions when you were "right" about shorting first, and you will end up with both stocks in a fair and market-neutral spread. Please understand this is a very basic overview of pairs trading.
OPENING PRICE & INDICATIONS
I have some questions regarding opening prices and indications. If, for example, a stock indicates premarket @ 27 x 27.50 with the previous day's close at 27, does this indicate that the specialist is likely to open the stock higher?
Or if a specialist indicates a higher opening for a stock, is he obligated to actually open the stock higher? Say the indication for a stock premarket is 35 x 35.50 and the previous day's close was 34.80. Does the specialist have to open the stock at a price within his indication-in this case between 35 and 35.50?
Also, once two companies announce a merger, does this mean only one specialist will handle both companies' stocks?-tito
First of all, the specialist is indicating that the opening price will likely be up from the previous close. At the same time, he's looking for sellers in that price range. Track your stocks to see how actual openings relate to preopen indications.
As for opening within his indication, the specialist doesn't "have" to, for a couple of reasons. For one, he may receive a large sell order at the last second, changing the opening price. For another, he is actually "asking" for help from traders and institutions, and the responses could affect the price as well.
The specialist will likely open the stock within the range indicated. Remember, he can change that indication often prior to the stock's actual open.
Finally, the change in specialist posts occurs after the merger or acquisition is completed. Specialists for the "buying" companies often keep the stock at their posts. Between merger announcement and completion, the same specialists trade the individual stocks.
HIDDEN LIQUIDITY
I have read something about Goldman Sachs having a big liquidity pool. Can you tell me what that is?-Karen
Wow, you really keep up with innovations within the industry! Yes, GS and REDI have given us access to their hidden pools of millions of shares from various sources around the US. Our traders can now send their orders via what is called "SigmaX," which routes first to these hidden pools (by "hidden," I mean not shown on Level 1 or Level 2 quotes), and seeks the best price. If they are not able to fill at a better price than your limit, they go to the general market and allow you to "rest" on the ECN, or the exchange of your choice.
This is a tremendous benefit to our traders since price improvement can amount to tens of thousands of dollars every year. While we're at it, another benefit of having Goldman Sachs as our clearing partner is the firm's access to shortable stocks. Without being able to short from this enormous pool, our traders would have a much harder time trading various strategies, including pairs trading.
Things are constantly changing, and it's important to stay ahead of the game!
E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."
Originally published in the April 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2006, Technical Analysis,
Inc.
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