Q&A
Since You Asked
| Professional trader Don Bright of Bright Trading,
an equity trading corporation, answers a few of your questions. |
Don Bright of Bright Trading
|
INDEX ARBITRAGE
Don, I have enjoyed your commentaries in STOCKS & COMMODITIES.
Can an individual buy a "basket" of stocks economically enough
(say with your firm) in order to perform index arbitrage: selling futures
versus buying cash and vice versa? "Spread trading" or hedged
strategies appeal to me; what valid spreads do you teach or trust, and
can an individual perform S&P or E-mini arbing almost as effectively
as the floor traders or market making firms? Thank you.
- David Pfizenmaier
You've brought up a couple of interesting ideas about arbitrage methodology.
If your costs are low enough as you mentioned (trading with a proprietary
firm), then you can do very well trading baskets of individual stocks vs.
a futures contract. With point-and-click trading and by using links to
the exchanges or electronic communications networks (ECNs), a trader can
almost simultaneously execute orders upon finding a discrepancy in pricing.
That covers the tactical aspect of performing the functions necessary.
Now for the strategic aspect of these methods. Hedge baskets can range
from a handful of high-cap stocks to the entire Standard & Poor's 500,
for example. A good arb trader will find a proper sampling that will reflect
the larger index, but this is not easy. You will find that oftentimes adjustments
are needed based on news items, earnings warnings, and so on. Our traders
don't generally hedge with the futures, preferring to use them instead
as immediate indicators to tell which side of the pair trade or spread
trade they want to open first. Thanks for reading the column, and thanks
for the kind words!
COMING SOON
I have been told there are new margin rules and requirements for
active traders. Can you explain the differences?
- Leon T. Phoenix
I will be doing a complete review of the major changes in the regulations
for active traders in the very near future. Since there are several compliance
issues involved, I want to wait for some clarification before publishing
my review. By next month I should have a good handle on the whole thing.
I have read conflicting stories already, and don't want to fall into the
trap of giving misleading or slanted information. I did note there is a
"self-policing" aspect to the new rules that should prove interesting.
Please check back next month.
EXAGGERATED ADVERTISING
I have been reading your column for some time now, and notice
you seem to be forthright when it comes to your opinion on trading programs
and software and the like. I recently saw an ad for spread trading on TV,
and the ad made it sound great. It showed an example of a company that
is about to make an earnings announcement, and the system shows you how
to make money whether the stock goes up or down. The example showed the
company putting out an earnings warning rather than good earnings, and
they claimed to make a large profit from the stock price decline. Is any
of this possible?
- J. Pack, Grass Valley, CA
Don't get me started! I did see (what I am pretty sure is) the same infomercial.
They claim "limited risk" and large potential profits from a
stock move. I thought it was humorous they used the same sales tactics
as the people selling knives and other household products ("Buy within
the next 30 minutes and receive this book and that CD for no additional
cost!").
I am pretty sure their tactic is something as mundane as buying option
straddles (buying both a call and a put of the same strike price on the
same underlying security), or strangles (buying calls and puts at different
strike prices on the same security), with the hope the stock price will
move significantly. As with any option purchase strategy, the buyer is
limited to only losing everything they invested in the options. And, yes,
they can profit from a significant move in the stock price (obviously,
if you can read the future you can make money!). What I find in all of
these option "secrets" is they fail to inform the consumer that
the option market makers are expert traders and will price the calls and
puts based on anticipated stock movements. This generally prevents most
option buyers from making money, and usually leads to significant losses
from the time decay in price. Since most of the money being made in options
is from their sale, not their purchase, you must assume some risk to better
your chances of profit.
Thanks for reading the column, and for helping to make others aware
of potential pitfalls.
RATES WITH BLACK-SCHOLES
Can anyone tell me what rate to use and for what time period in
calculating the value of warrants (using the Black-Scholes model) with
expiration dates that don't match any of the US government securities maturities?
For example, what rate would I use for a warrant that expires two years
and five months from the valuation date? Thanks.
- eebarn@about.com
The Black-Scholes model allows for the difference between "long"
money and "short" money (whether you are finding uses for excess
cash in the bank, or borrowing money to take advantage of a current market
condition). I suggest you figure out your current position, and either
add or subtract half of 1% to cover your costs. Then use the actual number
of days to determine your daily premium decline. In addition to interest
rates in Black-Scholes, you need to consider the historical volatility
of the underlying security, and the current implied volatility to see if
the pricing is at/over/under fair value. Hope this helps.
Don Bright is with Bright Trading (www.stocktrading.com), a professional
equity corporation with offices around the US. E-mail your questions for
Bright to Editor@Traders.com, with the subject line direct to "Don
Bright Question."
From an article originally published in the November 2001
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2001, Technical Analysis, Inc.
Return to Novmeber 2001 Contents
