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 |
MINIMIZING RISK IN PARIS TRADING
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 arbitrage pricing theory 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.
CALCULATING FAIR VALUE AT OPENING
In your article on leading indicators (I know it was a while ago),
you wrote, "We use a fair value calculation, with beta weighting, to determine
the prices used." I understand about calculating fair value for the market
and using this as an indicator, but did you mean calculating fair value
for a particular stock? If so, how is this done? -Jon Myers
I think it's probably time that we review the thought process behind
our "opening only" strategy. What we do is place bids and offers, prior
to the market opening, for a select group of stocks. We do this in anticipation
that a few of these stocks will open with a gap, to either the upside or
the downside. We know that if a stock opens with a gap in price, then it
is likely that the NYSE specialist is providing shares "against" the imbalance.
The way the game is played is pretty simple, and knowing that the specialist
will not add to the imbalance - and is usually accommodating the excess
shares - gives us an edge when we participate on the same side as the specialist.
This, obviously, involves fading the opening gap.
If, for example, IBM were to open up 90 cents from the previous day's
closing price, we would assume that the specialist is selling shares on
the open. We also make the assumption that the specialist will likely cover
his short sale quickly after the stock begins trading. Over the years we
have found that by "helping out" the specialist by adding liquidity, we
have been rewarded with trading profits.
Back when I was trading on the exchange floor, I used to get a notice
from the specialist(s) when they were anticipating that a particular stock
would open up or down with a gap. I would then offer to buy or sell shares
up or down a certain amount from the previous closing price. I might say
that I would sell 5,000 shares up 50 cents, 10,000 shares up $1, and so
on. I would never know for sure how many shares I would be selling until
the stock opened.
These days, we do our best to calculate where a stock might open by
using a fair value calculation based on where the S&P futures (or the
eminis) are trading just prior to the NYSE open. If the market is showing
an estimated higher opening of 1%, then I would assume that my stocks should
open up 1% as well. I now envelop that anticipated opening price with a
bid a bit lower, and a short sale a bit higher. The fair value number is
simply the cost of carrying the stocks vs. buying the futures (try www.programtrading.com).
I personally enter bids and offers on six or seven of the same stocks
every day, and hope to make from a few pennies to a quarter or so on those
that I'm filled on. We have traders who enter a couple of hundred orders
every day, from a few hundred shares to a few thousand shares (I enter
2,000 to buy and 2,000 to sell short on each stock).
So in a nutshell, we act as a surrogate specialist at the opening each
day, and quickly enter a closing trade to capture small profits. This strategy
has worked for a couple of decades, and is still one of the better overall
trading strategies employed by Bright traders. This is capital-intensive,
but is very consistent.
E-mail your questions for Bright to Editor@Traders.com, with the
subject line direct to "Don Bright Question."
Originally published in the August 2005 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2005, Technical Analysis, Inc.
Return to August 2005 Contents
