Since You Asked

To short a spread pair is just a definition. If I short a $32 stock and buy a $30, I have effectively shorted the spread pair for $2.00. Some consider it as buying for a ($2.00) — depends on whether you’re an old option spread trader like me. Obviously, if you buy the $32 stock and short the $30 stock, you have “bought” the spread.

Now let’s get back to the basics of spread/pairs trading. We track hundreds of correlated pairs on a daily basis. We keep track of many variables, one of the most important of which is the six-month trading range. For example, let’s use that $32/$30 pair of X and Y. Now, by using a simple six-month price graph, we see that the pair has crossed the $2.00 line several times. It has a high differential of $6.00 and a low differential of $1.00 during this time frame. We look at all the fundamentals as well. We tend to run various time frames, determining how much the spread moves on a daily basis (so we know how much to expect from our intraday/intraweek trades). If we see the pair starting to trend upward from $2.00, we would buy the pair. If it went against us, we would likely buy another layer at $1.50 or so (10% of the six-month range). We would be buying and selling the pair while leaving on a core layer to take advantage of extended trending.

So to take advantage of this core pair, we would trade the noise — simply meaning that we would do several short-term trades while waiting for it to get to a high-enough level to close it out completely. Money is made by these multiple trades, so even when we have to wait a while for it to cross over a certain price level, we maintain profitability. We also teach our traders when to get out, as with any trade gone bad, for whatever reason.

We offset overall market risk by being dollar-neutral via share sizing of each stock. We also flatten out overall risk by having multiple pairs going all the time. We have also developed automated software to help monitor these multiple pairs.

WHAT’S YOUR FOCUS?
Don, I’ve followed your column and a couple of trading forums over the years. I realize your firm has hundreds of traders and the many strategies and techniques that they use, but could you help me figure out what a newer trader should be focused on during the trading day? Have things changed a lot over the last couple of years? How does an average trading day go? —demontrader

First off, thanks for reading the column! And, yes, you’re correct in that we have multiple and overlapping strategies that our people engage in. Let me cover what I expect my “boot campers” to do during a normal trading day.

We arrive at our workstations no later than 8:30 am. Since we have already researched our stocks for the opening-only strategy, we only have to check for pertinent news items (up/downgrades, earnings announcements, and so on). At 8:45 we listen to our firmwide chat for insight from our top traders and corporate. By 9:20 we have determined our opening envelopes for our (20 to 100) orders premarket. Most use automated programs for the opening strategy, allowing for more orders, of course.

We are generally done with the openings by 9:45 or so, and then we switch to our normal trading activity. We will have our portfolio of correlated pairs pulled up on what we call the “portfolio watcher” — this tool tells us if we have positions to add or take profits on. This activity varies by traders, from a couple of pairs to a couple hundred. Once again, we have automated programs that can send orders for us based on predetermined price levels. Don’t get me wrong; we have many traders who do not run automated programs, preferring old-school short-term trading.

Many traders still focus on what we call our “children” — simply two or three symbols that we trade day in and day out. This makes not having to jump to the stock du jour, which is like going to someone else’s poker game every day instead of bringing other players to ours.

We watch our pivot points, prem/disc to fair value all day long to help determine our entries and exits. We are cautious during the slower time of day (11am–2pm ET). This time frame is where discipline must prevail, so we don’t try to force something to happen. The auto-programs help with this, of course.

Around 2pm we get refocused, almost like the start of a new trading day. Activity picks up, and volume increases. At about 2:45 we look for the phenomenon we call on the West Coast the “noon balloon” — simply a time frame when the market generally rises (until about 3:05 or so). We then prepare for the 3:30–3:40 market directional move. Since the market on close imbalances are published at 3:40, some traders seem to know which direction is favored that day, and that 10-minute period is telling. We then prepare for the regulatory imbalances that come out at 3:40 and 3:50 and trade accordingly. We have an edge, since our trading platform provides 30-second updates on these imbalance numbers as they are offset.

We watch for closing prices, recap the trading day in our journals. Come in the next morning, as my friend Ben Lichtenstein says, “refreshed, refueled, ready for a new day.” Hope this helps.