Q&A
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 |
INTEREST RATES & STOCK SALES
With interest rates on the rise again, I am concerned about how brokerage
fees affect traders. My firm already charges a hefty fee for debit balances,
and I am confused about the cash that comes in from short stock sales --
is that something my firm should consider? -dallasequity
Excellent questions. Let me try to help find some answers. When you
buy securities, your broker allows you to buy on margin (in most cases),
charging you that "hefty fee" you mention. The best way around that is
to keep more money in your account to cover purchases, but you have to
consider what you're giving up as well. You're forgoing the interest that
you could be earning in an interest-bearing account, and this number is
part of your "cost of carry" calculation that you must consider in all
stock purchases. For example, if you could get a 6% return from a government-backed
security (basically risk-free), you first have to anticipate that you will
overcome that with either stock appreciation or dividend yield, or a combination
of both.
Now, when it comes to interest on short stock sales, you have to speak
directly with your broker to see how they handle that cash transaction.
If you are hedged using options, you may very well have an almost risk-free
overall position, with extra cash coming in from the short stock sale (that
is, long call, short put, or short stock, called a "reversal" or "reverse
conversion"). Some retail firms don't pay anything on the short sale, claiming
that they have to borrow the stocks and pay a fee to do so. This is not
always the case, since there is often long stock under their umbrella as
well; this way, they don't have to go outside of their own firm to provide
the short stock.
Our traders receive interest on short stock, with a slight differential
from the clearing firm between what they pay on debit balances and what
they receive from short-stock sales. Be sure you understand exactly how
your firm handles all of this, because more and more firms are relying
on the interest spreads to make their money.
ORDER FLOWS & OPENING PRICES
I'm extremely interested in learning about order flows and how the
specialist sets the opening price of a stock and/or index. In particular,
can you give me a description -- or better still provide some papers and
links -- that describes how order flows happen overnight? Into the open,
how and why do markets gap up or down, and when and why do orders get filled?
When, and under what circumstances, do specialists make money?
I have heard several stories. One of them goes like this: Suppose
there are several buyers overnight who want to buy at the close of the
previous day. Knowing this, the specialist then opens the market lower
(that is, gaps lower) so he can start buying at the open at a lower price,
and selling to those who made limit orders overnight (that is, those who
have already expressed interest in buying). Given this scenario, I'm confused
as to how the specialist could arbitrarily open the price lower. Who does
he buy from at the open at a lower price, and why would that person sell
at a lower price compared to yesterday's close? -- Mahesh
First off, let's correct the assumption that the specialist can just
gap up or down at will. He cannot. Your premise of there being buyers on
the close from the previous day, and the specialist who then opens the
stock lower in hopes of selling to these opening orders at or higher than
yesterday's closing price, is not valid. Say a stock closed at 33.90, and
overnight buyers place an opening only order to buy shares at 33.90; if
that stock were to open lower (due to excess opening only sell orders),
then these buyers would be filled at that same lower price. There are only
two times during the trading day you will find a single-price market: on
the open and on the close. So, opening only would give the same price to
all participants.
Let's cover this concept from the beginning. Overnight, orders come
in to buy (at market and with price limits), and orders to sell (again,
at market or with price limits). The specialist matches these orders as
well as he can to give a fair price to all concerned. This may require
a higher opening price, due to excess buy orders, and limited sell orders.
He then goes to his "book" of previously placed orders, sometimes good
until canceled (GTC), sometimes day orders, sometimes others. If the excess
buy orders cause him to search up the ladder 40 cents or so, he may choose
to sell some of his own inventory, or even participate by selling short
at this opening price. If he sells short on the opening, then he may quickly
buy the stock back at lower prices, thus creating a profit for his firm.
This profit is deserved because the specialist, just like every other market
participant, has taken on the risk of providing shares to the marketplace.
E-mail your questions for Bright to Editor@Traders.com, with the
subject line direct to "Don Bright Question."
Originally published in the January 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
Return to January 2006 Contents
