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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IS DOWNSIDE VOLATILITY UP?

Did you see any increase in downside volatility after the uptickrule was removed last year? Were intraday short trades becoming more profitablewithout the cushion of an uptick rule? And what's your sense of how thisnew ruling might affect short strategies if it is broadened to more stocks?

I trade the Russell 2000 almost exclusively short and am a littleconcerned about how any regulations that involve short sales may affectthe movement of indexes.--lindq

Actually, it's kind of interesting. Summer 2007 showed a big move inthe volatility index (VIX) that was actually a thorn in the side of manybrokerages and clearing firms. The September contract was being shortedat (near) all-time highs, while traders were hedging with January contracts.Well, the January contracts didn't move as expected, causing a major ripplewithin the industry. Many firms stopped their traders from engaging incalendar spreads on the VIX.

And interestingly, the first couple of months without the uptick rulesaw a big rise in the overall market. Our traders (in correlated pairsgroups) were thrilled by not having to wait for upticks, but since we arehedged, I don't feel we had any effect on the overall market movement.We did see an increase in overall pairs and merger volume during the last12 months.

Now, about the regulators and bureaucrats blaming short-selling forthe recent market selloff and the overall state of the economy -- my opinionis they're looking for scapegoats. When all major economic indicators pointin one direction, and we have so many banking problems, I hardly thinkthe traders are responsible.

Long answer to a short question. The short answer is "not really" tothe downside question. Index arbitrage should not hurt your strategy, andany big players wouldn't push indexes straight down. If they tried anythinglike that, the arbitrageurs would have a field day.

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DARK POOLS OF LIQUIDITY

From Don Bright: Some background. The major broker and investmentbanks have implemented "dark pools of liquidity" for large share size ordersnot displayed to the public. Many traders are fearful this will cause damageto transparency and market pricing. Although we've had iceberg orders andreserve orders for years, this new process takes some explanation. Somequestions via email:

1. Don, I posted a reference to an SEC document a while back thatasserted something to the fact that trades can get reported and settledafter hours on overseas exchanges. Not that it specifically refers to darkpools, nor does it exclude them (from my understanding). Do you agree?If so, how do such records get reflected in the tape, and wouldn't a sufficientnumber of these methods of recording transactions distort things like chartvolume over the course of time?--dt

2. I called a couple of dark pools and a few of them said theyhad up to 90 seconds to report and one said up to five minutes. Is thatright?--Jaytrader

Don Bright's reply: Okay, let's follow the money for a second.These transactions have to settle and/or deliver certificates (rare, butit's still done). For the cash to move from one place to another, the transactionshave to be matched and offset (contra) by both exchanges and clearing firms.So there will have to be a record kept of the transactions. Are some tradesposted offshore? Sure, but there are strict rules in place, and they toohave to settle and be paid for, or else the people selling the shares can'tget their money.

As far as a dynamic change goes, that's possible, but I don't thinkthat anything in the next few years will affect the way my people trade(other than the regulatory intervention, preborrows, and all of that).

I have been involved for 30 years, and "they" that many refer to hasactually been "us" in many regards. There will always be those trying tobend the rules, but since we are now in a global, computerized marketplace,the ability for more transparency, not less, especially when "followingthe money," will keep most of this in check. As I mentioned, many of ourguys are making good money using dark pools.

3. So how about sharing a little industry knowledge on how darkpools and things like iceberg orders work since you are our resident expert?My understanding is that while delayed, those orders do get reported completelyto the tape. Is that true? --dandxg

Don Bright's reply: All the dark pool trades get reported within30 to 90 seconds, the officials tell me. Not sure if I posted this infoyet:

    www.redi.com/forms/algo720.pdf

    www.stocktrading.com/sigmax.pdf

Basically, if we use the SigmaX smart router, it will go search the darkpools between National Best Bid/Offer (NBBO) pricing and snag price improvementwhen available. For example, if bid is 0.05 and offer is 0.09, we can senda smart sell order and it might very well hit a 0.07 bid. We can post betweenbid/offer as well. As always, as in iceberg orders, we can display 500,but have a 5,000-share order. This is another reason why tape reading isstill so important to trading.

And by the way, about traders "finding out" about a million-share sellorder or something -- I'm not saying it's not possible, but it's still illegalto act on this information. I'm not naïve enough to think things likethat don't take place, but the dark pools should help with this via prenegotiatedtrades, just like in the old days.

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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 October 2008 issue of Technical Analysisof STOCKS & COMMODITIES magazine. All rights reserved. © Copyright2008, Technical Analysis, Inc.

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