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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IS DOWNSIDE VOLATILITY UP?

Did you see any increase in downside volatility after the uptick rule was removed last year? Were intraday short trades becoming more profitable without the cushion of an uptick rule? And what's your sense of how this new ruling might affect short strategies if it is broadened to more stocks?

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

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

And interestingly, the first couple of months without the uptick rule saw a big rise in the overall market. Our traders (in correlated pairs groups) were thrilled by not having to wait for upticks, but since we are hedged, 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 last 12 months.

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

Long answer to a short question. The short answer is "not really" to the downside question. Index arbitrage should not hurt your strategy, and any big players wouldn't push indexes straight down. If they tried anything like 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 investment banks have implemented "dark pools of liquidity" for large share size orders not displayed to the public. Many traders are fearful this will cause damage to transparency and market pricing. Although we've had iceberg orders and reserve orders for years, this new process takes some explanation. Some questions via email:

1. Don, I posted a reference to an SEC document a while back that asserted something to the fact that trades can get reported and settled after hours on overseas exchanges. Not that it specifically refers to dark pools, 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 sufficient number of these methods of recording transactions distort things like chart volume over the course of time?--dt

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

Don Bright's reply: Okay, let's follow the money for a second. These transactions have to settle and/or deliver certificates (rare, but it's still done). For the cash to move from one place to another, the transactions have 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 trades posted offshore? Sure, but there are strict rules in place, and they too have to settle and be paid for, or else the people selling the shares can't get their money.

As far as a dynamic change goes, that's possible, but I don't think that 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 has actually been "us" in many regards. There will always be those trying to bend the rules, but since we are now in a global, computerized marketplace, the ability for more transparency, not less, especially when "following the money," will keep most of this in check. As I mentioned, many of our guys are making good money using dark pools.

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

Don Bright's reply: All the dark pool trades get reported within 30 to 90 seconds, the officials tell me. Not sure if I posted this info yet:

    www.redi.com/forms/algo720.pdf

    www.stocktrading.com/sigmax.pdf

Basically, if we use the SigmaX smart router, it will go search the dark pools between National Best Bid/Offer (NBBO) pricing and snag price improvement when available. For example, if bid is 0.05 and offer is 0.09, we can send a smart sell order and it might very well hit a 0.07 bid. We can post between bid/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 is still so important to trading.

And by the way, about traders "finding out" about a million-share sell order or something -- I'm not saying it's not possible, but it's still illegal to act on this information. I'm not naïve enough to think things like that don't take place, but the dark pools should help with this via prenegotiated trades, 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 Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.

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