Q&A

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Since You Asked

Confused about some aspect of trading? Professionaltrader Don Bright of Bright Trading (www.stocktrading.com), an equity tradingcorporation, answers a few of your questions.

Don Bright of Bright Trading

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HEDGING THE MARKET

I was reading about taking opposite positions at the same time andreferring to that as hedging. Wouldn't that be the same as not being inthe market at all? Why put forth the extra effort of being in the marketwhen you're not going to profit either way? Or do I have this completelywrong? - Iron Fist

The basics of hedging are this. You try to limit or eliminate "marketmovement risk" by being (for example) long 2,000 shares of stock A (thestronger stock based on your criteria) and short 2,000 shares of stockB (the weaker stock). You then look back over a year, five years, and soon, and see if their prices have criss-crossed over time. If stock B is$3 higher than stock A, you would short B and buy A. If the prices crossed,you would make $3.00.

Another type of hedging is selling futures contracts at a premium tofair value, and buying the underlying securities. Then (often the sameday) you reverse the trade at a profit by buying the futures at a discountand selling the equities (I'm using the Standard & Poor's 500 or eminisin this example).

Either example reduces market risk. With the pairs of stocks, you collectinterest on the short side (if you're a "prop" trader - one who tradesfor a firm and uses the firm's capital - not generally given to retailtraders). If you are using the futures, you have a mathematical edge basedon interest rates (cost of carry).

If you would like more information, send me email here at the magazine.

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ABOUT MARKET MAKING

There was a question I asked about traders "spoofing," as in postingfake bids, asks, and so on, and you clearly did not recommend taking thatposition. I notice on some of the stocks I trade now on the NYSE, morenow than before, that when the futures are rising, the bids get big andthen someone is just sitting on the offer with a 12-lot on NYSE or a two-loton ARCA soaking everything up. When the futures go down or begin consolidating,the bids just pull without too many prints going off on the bids. Is this"spoofing" or market making? What is market making as a strategy? - Greg

Good questions. Let's start off with the question about spoofing. Whilethis activity does take place, it is often blamed for other, more rationaland legal strategies. Many program traders have triggers set off when thefutures hit certain premium or discount levels (premium = trading higherthan current fair value would indicate; vice versa for discount). Thesearbitragers, knowing they can sell futures immediately, may place bidsat price levels that would give them a mathematical advantage if theirbid is hit. So if the futures stop trading at a premium, these traderswill cancel their bids on the underlying stock(s). This could appear tothe average person as "spoofing," although this is not the case.

This is not the classic form of market making, merely an example ofarbitrage. Market making is when a trader may choose to go along with theNYSE markets on both sides, bids and offers, hoping to scalp during timesof intraday movement. If you think about it, the NYSE specialists havebeen making markets for 200 years. The advantage a good trader has, evenover the specialist, is that they can pick and choose when they want toparticipate in the trading of a certain stock. The specialist is requiredto make a fair and orderly market even if he/she doesn't want to.

As a strategy, market making gained popularity during the 1990s withthe advent of the "SOES bandits" (small order executive system). This didn'tlast long, but the basic idea was to place bids and offers within the pricesposted by NASDAQ market making firms in hopes of taking away some of theedge the market makers enjoyed. As with many things, computer programmerswere able to develop "SOES busters" software as a countermeasure.

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PROVIDING LIQUIDITY

I was wondering if you could expand on this. I know someone who talksabout providing liquidity and he makes over $100,000 a month, which I thoughtwas pretty good, but maybe it's not. What do your guys make who use thatstrategy, and where can I find out more about it? -88888accountant

First off, it's doubtful anyone makes that kind of money net by providingliquidity alone. They may receive that much and then pay a considerableamount for "taking" liquidity. Keep in mind there are a lot of unsubstantiatedclaims made in trading. (No letters, please; anything can be done in trading.I'm just commenting on exaggerations.)

A definition of what I'm referring to: If you place a bid or offer awayfrom the current trading market on a stock, you are providing liquidityfor others to take your offer or hit your bid. If you sell at the bid priceor buy at the offering price, then you are taking liquidity.

New to the dynamics involved is that the ARCA ECN is paying tradersfor providing liquidity on listed stocks (previous liquidity payments werefor OTC stocks only). Our traders receive a considerable rebate for doingthis. Our traders now park on ARCA and take on NYSE, thus not having topay for taking liquidity on ARCA. This helps offset the fact that we'regetting fewer price improvements since the advent of the hybrid system.

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E-mail your questions for Bright to Editor@Traders.com, with thesubject line direct to "Don Bright Question."

Originally published in the January 2007 issue of Technical Analysisof STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2006, Technical Analysis,Inc.

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