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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INTEREST RATES & STOCK SALES

With interest rates on the rise again, I am concerned about how brokerage fees affect traders. My firm already charges a hefty fee for debit balances, and I am confused about the cash that comes in from short stock sales -- is that something my firm should consider? -dallasequity

Excellent questions. Let me try to help find some answers. When you buy securities, your broker allows you to buy on margin (in most cases), charging you that "hefty fee" you mention. The best way around that is to keep more money in your account to cover purchases, but you have to consider what you're giving up as well. You're forgoing the interest that you could be earning in an interest-bearing account, and this number is part of your "cost of carry" calculation that you must consider in all stock purchases. For example, if you could get a 6% return from a government-backed security (basically risk-free), you first have to anticipate that you will overcome that with either stock appreciation or dividend yield, or a combination of both.

Now, when it comes to interest on short stock sales, you have to speak directly with your broker to see how they handle that cash transaction. If you are hedged using options, you may very well have an almost risk-free overall position, with extra cash coming in from the short stock sale (that is, long call, short put, or short stock, called a "reversal" or "reverse conversion"). Some retail firms don't pay anything on the short sale, claiming that they have to borrow the stocks and pay a fee to do so. This is not always the case, since there is often long stock under their umbrella as well; this way, they don't have to go outside of their own firm to provide the short stock.

Our traders receive interest on short stock, with a slight differential from the clearing firm between what they pay on debit balances and what they receive from short-stock sales. Be sure you understand exactly how your firm handles all of this, because more and more firms are relying on the interest spreads to make their money.

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ORDER FLOWS & OPENING PRICES

I'm extremely interested in learning about order flows and how the specialist sets the opening price of a stock and/or index. In particular, can you give me a description -- or better still provide some papers and links -- that describes how order flows happen overnight? Into the open, how and why do markets gap up or down, and when and why do orders get filled? When, and under what circumstances, do specialists make money?

I have heard several stories. One of them goes like this: Suppose there are several buyers overnight who want to buy at the close of the previous day. Knowing this, the specialist then opens the market lower (that is, gaps lower) so he can start buying at the open at a lower price, and selling to those who made limit orders overnight (that is, those who have already expressed interest in buying). Given this scenario, I'm confused as to how the specialist could arbitrarily open the price lower. Who does he buy from at the open at a lower price, and why would that person sell at a lower price compared to yesterday's close? -- Mahesh

First off, let's correct the assumption that the specialist can just gap up or down at will. He cannot. Your premise of there being buyers on the close from the previous day, and the specialist who then opens the stock lower in hopes of selling to these opening orders at or higher than yesterday's closing price, is not valid. Say a stock closed at 33.90, and overnight buyers place an opening only order to buy shares at 33.90; if that stock were to open lower (due to excess opening only sell orders), then these buyers would be filled at that same lower price. There are only two times during the trading day you will find a single-price market: on the open and on the close. So, opening only would give the same price to all participants.

Let's cover this concept from the beginning. Overnight, orders come in to buy (at market and with price limits), and orders to sell (again, at market or with price limits). The specialist matches these orders as well as he can to give a fair price to all concerned. This may require a higher opening price, due to excess buy orders, and limited sell orders. He then goes to his "book" of previously placed orders, sometimes good until canceled (GTC), sometimes day orders, sometimes others. If the excess buy orders cause him to search up the ladder 40 cents or so, he may choose to sell some of his own inventory, or even participate by selling short at this opening price. If he sells short on the opening, then he may quickly buy the stock back at lower prices, thus creating a profit for his firm. This profit is deserved because the specialist, just like every other market participant, has taken on the risk of providing shares to the marketplace.

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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 January 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.

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