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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HEDGING THE MARKET

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

The basics of hedging are this. You try to limit or eliminate "market movement risk" by being (for example) long 2,000 shares of stock A (the stronger stock based on your criteria) and short 2,000 shares of stock B (the weaker stock). You then look back over a year, five years, and so on, 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 to fair value, and buying the underlying securities. Then (often the same day) you reverse the trade at a profit by buying the futures at a discount and selling the equities (I'm using the Standard & Poor's 500 or eminis in this example).

Either example reduces market risk. With the pairs of stocks, you collect interest on the short side (if you're a "prop" trader - one who trades for a firm and uses the firm's capital - not generally given to retail traders). If you are using the futures, you have a mathematical edge based on 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 posting fake bids, asks, and so on, and you clearly did not recommend taking that position. I notice on some of the stocks I trade now on the NYSE, more now than before, that when the futures are rising, the bids get big and then someone is just sitting on the offer with a 12-lot on NYSE or a two-lot on 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. While this activity does take place, it is often blamed for other, more rational and legal strategies. Many program traders have triggers set off when the futures hit certain premium or discount levels (premium = trading higher than current fair value would indicate; vice versa for discount). These arbitragers, knowing they can sell futures immediately, may place bids at price levels that would give them a mathematical advantage if their bid is hit. So if the futures stop trading at a premium, these traders will cancel their bids on the underlying stock(s). This could appear to the average person as "spoofing," although this is not the case.

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

As a strategy, market making gained popularity during the 1990s with the advent of the "SOES bandits" (small order executive system). This didn't last long, but the basic idea was to place bids and offers within the prices posted by NASDAQ market making firms in hopes of taking away some of the edge the market makers enjoyed. As with many things, computer programmers were 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 talks about providing liquidity and he makes over $100,000 a month, which I thought was pretty good, but maybe it's not. What do your guys make who use that strategy, and where can I find out more about it? -88888accountant

First off, it's doubtful anyone makes that kind of money net by providing liquidity alone. They may receive that much and then pay a considerable amount for "taking" liquidity. Keep in mind there are a lot of unsubstantiated claims 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 away from the current trading market on a stock, you are providing liquidity for others to take your offer or hit your bid. If you sell at the bid price or buy at the offering price, then you are taking liquidity.

New to the dynamics involved is that the ARCA ECN is paying traders for providing liquidity on listed stocks (previous liquidity payments were for OTC stocks only). Our traders receive a considerable rebate for doing this. Our traders now park on ARCA and take on NYSE, thus not having to pay for taking liquidity on ARCA. This helps offset the fact that we're getting 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 the subject line direct to "Don Bright Question."

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

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