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 |
KEEPING IT CONSISTENT
When you are performing analysis on a couple of stocks for a pair trade or some sort of relative performance, or for that matter comparing advancing issues and declining issues of a limited basket (say the sp100 basket), is it better to do a ratio (dividing the two) or a difference (subtract the two)? I have seen examples from different sources including pairtrade.com when dividing and subtracting were used. When I look at the differences between the two ways of looking at the data, I notice they basically mirror each other most of the time and are almost identical, but there are times when the ratio of the two shows a spike and starts to move quicker in the opposite direction than the difference of the two. What is your take on using these two different calculations? Is one better than the other? Why on some occasions does the ratio exhibit quicker and better trend movements than the other calculation?
In a basic spread chart, when you subtract the two different stocks or divide the two stocks so that you create a spread chart that shows more of a range-bound or oscillating quality to find those mean reverting signals, why do some people use a subtraction of the two stocks while others use a ratio or division of the two to create a new spread chart? --raker
If I understand your question, basically, we "ratio" share size to allow for neutral long/short values (with a certain percentage long or short, based on the fundamentals involved). These ratios change as the price of the stocks change. Now, for the performance analysis, we use average trading range (ATR) of the pair over a period of time. This helps us determine entries, add-ons, and exits, along with the amount of frequency we may seek for each pair.
Spiking pair spread prices tends to have us "let it run" after a certain level, settle down, and begin the higher frequency again. I use a pair trading chart where we put in, for example, 2 x CC minus 1 x BBY. CC = 24 x 2 = $48. BBY = 54. So the ratio spread is $6.00. If we are long BBY, we bought the spread for $6.00 in expectation that the ratio spread will widen out to $6.50 or so. Then we close the spread at $6.50. If we then wanted to be short BBY, we would sell the spread for $6.50, expecting it to narrow back to a mean.
I use eSignal for that -- myTrack works well, too (only $5.00 per month for research, no live feeds).
On REDI, we have a price difference chart that works fine, but it is only one to one, price to price.
It depends on your parameters for working with average trading ranges -- have to keep consistent, that's the main thing. I hope this helps -- this is so much easier to explain when discussed in person or in a mentorship environment to assure proper understanding of everything from terminology to general concepts.
FORMULATING TRADING PLANS
Don, I've heard you speak several times and you always mention that every trader should develop a trading plan. I have made up business plans before for other businesses, but nothing to do with my trading. Can you give some advice or examples of what we should be including in our plans? -- MichaelV
Good question. Imagine that you were going to a banker in hopes that he would lend you $100,000 to begin your venture into stock trading. This is quite a stretch, as you can imagine. What would you show him? Not just projections of possible profits, right? He would want to see several basic bits of information including, but not limited to, markets and instruments to be traded (NYSE, NASDAQ, futures, or options, for example), but he would then want to know your time frame (scalping or daytrading, swing trading, portfolio management, mergers, and so on).
He will want to know why you think you're qualified to make money in the trading arena, so you should detail your background, but more important, outline what you're going to do to improve your future results as time goes by. To help make some of this easier, I'm going to offer you this modified plan and link from our training program, available on www.stocktrading.com/TradingPlanTASC.htm.
Good luck with your trading.
E-mail your questions for Bright to Editor@Traders.com, with the subject line direct to "Don Bright Question."
Originally published in the February 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
Return to February 2007 Contents