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.
Survival of the fittest
Don, I read your article about the subpennies and high-frequency trading. I have also read that these new demons might very well kill each other off in the near future. What steps are you and your traders taking currently to help offset these challenges?
Good question, I’ll try to give you a few ideas. The idea of “parking” on a limit price in hopes of collecting 0.002 or so in liquidity rebates seems sort of silly nowadays since these subpenny orders can flash in front you at the rate of thousands per second. What happens when you have 1,000 shares offered at 42.30, for example, is that these flash orders will go in offered at 42.2999 or similar and take the order from you. The only time you’ll be filled is when there is a large-enough order or a higher limit, allowing the price to go a few pennies against you. This can cost a lot of money. The other alternative is for you to basically lose a penny and hit the prevailing bid price. Either way, you’re losing money.
What we have found is that there is much less of this going in with 100-share orders. As a result, many of our traders will trade in 100-share increments, more stocks (pairs generally), and eliminate the subpenny losses. On the more liquid stocks, especially higher-volatility issues, we can take out offers and hit bits the way we used to back in the day.
I understand that Bright Trading is heavily involved in pairs trading, and does quite well. My question is about managing the risks involved. Some of the overall market movement risk can be cut down because you are somewhat market-neutral with a pair, long one stock and short another. How do you maintain the market neutrality with a single pair, and does adding more pairs help or hurt the overall risk?
We try to keep it simple when looking at overall market neutrality. Rather than analyze every trader’s pick of pairs, we generally just look at long dollars vs. short dollars. We, of course, have to be aware of “short” exchange traded funds (Etfs) and so on that would obviously skew that risk control, but most traders use equities for their pairs trading (many do use baskets vs. Etfs, however).
Now, as far as spreading the risk via more pairs is concerned, I’m a big fan, even as it relates to using smaller orders (see previous answer regarding subpennies), which we feel are executed better. The analysis of the stocks is primary, and we tend to like the better-valued stocks to be long vs. the growth stocks to be short. However, be extra careful when doing this analysis. Be aware that the lower-capitalized companies may be takeover candidates — another risk altogether. Overall, yes, we prefer to see several pairs within a sector, and multiple sectors in a portfolio. This helps eliminate consolidating too much risk in a small group of stocks.
We then move to frequency of trading for capturing profits. When we determine how much “should” be made from each layer of a pair (and how many layers we can go with overall), we must be diligent in taking these profits. This profit taking is actually a good method of risk control as well, since when we back down to even or one layer, the risk is actually or nearly nonexistent.
To address the movement in stock prices within a pair, we have elaborate data banks and spread history files that will allow us to modify our share size per side when needed.
Hope all this helps!