Q&A

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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

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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.

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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.

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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.

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