Q&A

Since You Asked

with Don Bright

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. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.

SURROGATE SPECIALIST
How many stocks do you typically tell a trader to focus on at one time? I’m talking about someone who’s not automated but basically a surrogate specialist in his stocks — would three or four stocks be about the right number?
— ListedGuru

Thanks for the question, and since we all must adjust our mindset in this ever-changing world of trading, very timely.

We teach our new traders several ways of approaching the market, and one of them is the “surrogate specialist” approach. Going back to my days on the trading floor, we would have pits with three to five primary stocks to focus on, with a handful of secondary stocks. Even though we were classified as market makers, we certainly “specialized” in these stocks.

You don’t encounter the term “tape reading” much these days, so I was surprised to hear it while listening to one of my top traders at our recent intensive weekend retreat (we hold these events twice a year for our traders — nice get-together, free updated training, and a chance to mingle with other traders). He was speaking about high-frequency trading (Hft), subpennies, and other obstacles facing traders these days. As it turns out, he said, because of (not in spite of) these things, we can now follow a ticker more closely for clues about immediate market direction. We set our tickers to several decimal places out so we could see all the subpenny Hft action.

So by following the tape, along with all the other factors of all-encompassing tape reading (premium/discount to fair value, depth of book, squawk box input, and so on), we can again read our “children,” as I call our three or four basic stocks, for intraday and short-term trading.

DIVIDEND PLAYS WITH AND WITHOUT CORRELATED PAIRS
I hear that your group’s trading pairs have been doing well with dividend plays. Is that true? I used to work some option strategies for capturing dividends but haven’t seen those working recently. Can you share some ideas?
— hedgemeister

Sure, but first a little background. A dividend is a distribution of a portion of a company’s earnings to shareholders, and it can be in the form of cash, stock, or property. With mutual funds, interest and dividend income from its portfolio holdings along with capital gains from stock appreciation and trading activity is paid out as a year-end dividend to the fund shareholders.

Dividend-paying stocks have a dividend amount that can be paid out quarterly or annually. They also may have special dividends that come along periodically. Traders and investors don’t just look at the dividend amount in dollars but also the dividend yield, which as a financial ratio is the annual dividends per share divided by the current price of the stock.

In pair trading, we collect dividends in two ways. The first is where the quality of the company is more critical, as we are holding a core position in a pair for extended periods as part of a portfolio (this is just an example).

Let’s say we are long Bank of America (Bac) and short JPMorgan Chase (Jpm) in a pair combination. Bac’s forward dividend is $2.56 (trailing was $2.40) with a dividend yield of 6.40%, whereas Jpm is $1.52 (trailing is $1.44) with a dividend yield of 3.60%. This pair could be held in a share-neutral manner and you would make 2.80% for the year by doing nothing. (Assuming, of course, both stocks stayed in relative similar performance to each other.) It would increase if you ran dollar neutral on the pair, which means you would own 105 shares of Bac for each 100 of Jpm.

We found interesting and rewarding pair combinations where the share size differences give us an advantage. For example, on a different pair, we are trading 100 shares by 200 shares (100 x 200) in order to capital balance. The stock we are short is 100 shares and we pay a $0.50 dividend annually on those 100 shares, but we collect $1.00 annually times our 200 shares (the stock we are long). This means we net out $1.50 for the year on this combination. Not bad.

The second strategy is the collection of dividends by overnight swing trades, with no intention of long-term holdings. Unlike the first strategy, in this one, the quality of the company may not be as critical if the trader is only holding overnight four times a year.

On ex-dividend day, the stock’s previous close price is adjusted (marked down) by the dividend amount that would be paid on the upcoming payable date. As there is an upward bias to stocks over the long sample, we note it assists slightly in offsetting the ex-dividend markdown. According to Ned Davis Research, dividend-paying Standard & Poor’s 500 stocks gained 10.19% per annum between 1972 and 2005 vs. 4.39% for nonpaying. Thanks to my trader friend Rob Friesen from www.pairtrader.com for much of this information.

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