Specialists, Regulations, the NYSE and YouBy Jeff ...



|Specialists, Regulations, the NYSE and You |

|By Jeff Linderman, Special to , 04/21/03 |

Isn't that special?

As you might recall, Dana Carvey's "Church Lady" character on Saturday Night Live was always on the lookout for aberrant behavior in seemingly honorable visitors to her talk show. Well, now comes word that the financial market's bastion of integrity, known as the New York Stock Exchange, may have produced some aberrant behavior of its own.

In a press release Thursday morning, the NYSE announced that it's conducting an investigation into the trading practices of several specialist firms. While no specifics were given, an article in The Wall Street Journal reported that front-running seems to be involved.

One fact that was mentioned in the release, of which I wasn't previously aware, is that fully one-third of all employees at the NYSE are involved in regulatory activities. On the surface, therefore, one might presume that the public is well protected. However, my view is that the regulatory department -- taken as a percentage of total headcount -- is sized way out of proportion. Such a massive regulatory force may indicate just how numerous the potential avenues for transgression are.

Is it possible that the entire structure of the marketplace is, at best, inefficient? Do the order-handling rules maintain a bias in favor of NYSE members as opposed to truly being run for the benefit of the investing public? I have a feeling that, given the litany of Wall Street indiscretions during the past two years, we'll be hearing much more on this topic.

Trading Places?

Having made literally thousands of trades on the NYSE, and having spent a fair amount of time examining market microstructure, I thought it would be a good idea to share some of my knowledge with RealMoney subscribers.

First, let's review how orders interact on the floor of the NYSE. Your buy or sell order reaches a centralized location known as a "post," via either an electronic system known as DOT, or designated order turnaround, or (for larger orders) a floor broker. At each post stands a specialist whose primary job is to monitor all order flow in a particular stock and make sure that each trade is executed at the best price available within the parameters of the market.

In active stocks, there are typically plenty of buy and sell orders that can be matched off against each other. In circumstances where a buy order arrives with no apparent seller (or vice versa), the specialist may take the other side of the trade as an accommodation. Again, that occurs within the context of the market for each individual stock based on current trading.

What is now being questioned is the possibility that a specialist observed a buy order and sell order coming in at roughly the same time and didn't match them up as required. Instead, the specialist may have allegedly bought the seller's stock in front of a customer who wished to buy and then immediately flipped it out to the buyer at a slightly higher price than he or she would've received if the order had been properly matched with the original sell order. That seller also might suffer, because if he/she had been able to meet the buyer's order directly, then both parties would have theoretically received a better execution.

Under this scenario, the specialist is really interfering in a transaction where his assistance is unnecessary. That's a polite way to describe the abusive practice of front-running. Admittedly, thousands of transactions occur on the floor all day long, and honest mistakes and oversights may happen. These are easily corrected. However, if what we're talking about here happened, it would be a willful and deliberate disruption of the trade process by the only entity who has access to all order information -- the specialist.

The NYSE does deliver real-time information regarding quote spreads and actual trades for the general public. In my next column, I'll get into the details of how you, the trader/investor, can make the most of the situation by understanding what a specialist may be doing in your stock and how to place orders for best execution.

|Specialists, Regulations, the NYSE and You, Part 2 |

In the first part of this column, I discussed the New York Stock Exchange's probe into the role of specialists with regard to customer orders.

To recap, specialists enjoy a privileged view of all trade flow in a particular stock. The vast majority of bids and offers on a transactional basis are routed to the specialist post via electronic systems such as designated order turnaround, or DOT. These orders are typically one-off situations, as the liquidity pool in the stock can generally accommodate an entire electronic order in a single execution.

Of course, size is relative. For example, a 5,000-share market order in Walgreen (WAG:NYSE - news - commentary - research - analysis) will typically trade within a 10-cent (or less) range from bid to offer. However, 5,000 shares in Longs Drug Stores (LDG:NYSE - news - commentary - research - analysis) will likely result in a temporary distortion of the spread and a poor execution.

It's important to distinguish between volume of transactions and actual share volume, because prices are really set by the larger players on any given day. Large orders are generally handled by floor brokers who are physically present at the post and have ongoing dialogue with the specialist.

Whether this "privilege by physical location" negates the so-called "level playing field" for all market participants has been a point of contention for many years, especially since the advent of electronic execution systems. That, however, is a subject for a future column. Right now, let's discuss the system as it currently exists and how to navigate it successfully.

What You See Is What You Don't Get

One of the main sources of NYSE information available to traders is known as the Time of Sales, or TOS, a real-time record of all transactions in a particular stock as well as all updates of the bid/offer size and price. In my experience, actual transactions on the TOS, if analyzed correctly, will yield more clues about what's going on than the size and spread of the bid/offer.

Transactions on the tape are objective, and bid/offer size is arbitrarily set by the specialist. Because every trader on the planet is receiving the same exact information, it's impossible to profit by using a simplistic strategy of buying when bids show up or selling when offers appear.

In fact, consistently profitable traders realize that something akin to a huge poker game is encompassed in the specialist's quote. If you take nothing else away from my column today, let it be this: At any given time, the specialist is showing you a market as he or she wants you to see it.

The specialist and floor brokers need to complete their big orders efficiently, and that means bluffing you into buying when they need to dump stock and vice versa. This is 100% legal, and it's simply a smart response to the current structure of the marketplace. Why should big buyers and sellers show their orders on the screen so that others can ride their coattails?

You Think I'm Here to Amuse You?

How does this work in practice? Let's say a stock is quoted $25 by $25.10, 1,000 by 25,000 shares. Stock for sale, right? Probably not. That big offer is not there for your enjoyment. In fact, the specialist is probably trying to buy stock either for his own account or on behalf of a floor broker. This is known as "shading" a market, and the goal is to get all of the short-term holders of the stock to hit the $25 bid and bail out of their holdings.

Because the floor brokers and specialist are in a physical position to know who the real players are, they're willing to take the tiny chance that some brand-new buyer will show up out of nowhere and actually take the 25,000 shares offered. When the institutional brokers or specialists are looking to sell, the entire process is simply a mirror image of that described here.

Occasionally, a big bid or big offer is a real indication that a stock is about to move in the expected direction. Typically, this occurs when a buyer/seller has found a counterparty who will take the other side of the trade at a previously agreed-upon level that's above/below the most recent quotes. A few nimble traders who instantaneously notice this may be able to squeeze ahead and score a quick profit. However, I'd venture to guess that over any statistically significant number of attempts, this would be a distinctly unprofitable strategy.

Thinking like an institutional broker or trader will give you better perspective. In my next column, I'll examine tape transactions, the NYSE limit order book and different types of order placement.

P.S. I wanted to alert you to an an all-day symposium on institutional equity trading, sponsored by Professor Robert Schwartz. He is well known for his work on market structure, and there will be speakers from academia, the buy side and sell side, ECNs and major exchanges. For those who can't attend, I anticipate writing another informative series of columns in early May based on the content of this conference.

|Specialists, Regulations, the NYSE and You, Part 3[pic] |

As I mentioned in Part 2 of this series, the Time of Sales, or TOS, provides informational updates to the specialist's bid/offer quote, as well as the size and price of actual transactions in an individual stock. However, the specialist's quote is subjective and might not represent the full picture of larger players' interest in a given stock. The more objective data from completed trades can yield clues to what the real story is.

Looking strictly at completed trades is a technique commonly known as tape-reading, and it's been used in one form or another for at least 100 years. I suggest combining tape-reading with other (admittedly nebulous) TOS quote information to better play the specialist chess game.

When comparing transactions on the tape with changes in the specialist's quote, certain informational incongruities occasionally appear. This creates an opportunity for you to either sidestep a potential adverse move or get positioned on the correct side of the market in that stock.

Are You for Real?

An important question any trader should always be asking is, just how real is that bid or offer on my trading screen? One of the ways I approach that conundrum is to look for behavioral inconsistency in the TOS during pronounced intraday market moves.

For example, when the Dow jumps or drops more than 50 points in a 10- or 15-minute time span (which usually happens at least twice in the first two hours of trading), how does a stock respond? There are potentially numerous responses, but generally speaking there are three possibilities: in line with the market, muted or excessive. A trader's opportunity resides in the muted or excessive responses.

Is That a Buy Order in Your Pocket, or Are You Just Happy to See Me Sell?

As previously discussed, a big offer may actually signal a concealed buyer. Let's say the market sells off, and your stock ticks down only slightly on light or moderate volume. I would ask you -- why isn't this big "seller" getting more aggressive? The indices are actively trading lower, not just slowly drifting down.

Shouldn't Mr. or Ms. Institution on the offer side of the market be concerned with the now-increased probability of another seller entering the picture? And as we know that no big traders show their total hand, doesn't this seller likely have more to do over the course of the trading day, thus providing even more incentive to be hitting bids? The conclusion is that a muted reaction to a sharp market move could mean that your stock is actually poised to head the other way.

Take the reverse situation. A stock is trading down moderately, but the specialist continues to show bids that are in proportion to the offer size. On the surface, indications are that the stock isn't exhibiting any unusual pattern.

Now, say the market indices drop. This stock begins to trade on heavier volume at lower prices. The size of the offer quote might not have increased, but the transactions on the tape are telling you a different story -- somebody wants out of the stock. Of course, simply reverse the thought process if there's a significant up move in the market.

One important caveat I would add is that each stock has its own pattern with regard to the pace and size of "in-line" reactions vs. potential trading opportunity. In my "quick market downdraft" example, liquid Dow stock McDonald's (MCD:NYSE - news - commentary - research - analysis) trading down 20 cents on 60,000 total shares doesn't have nearly the same implications as that same action in Jack in the Box (JBX:NYSE - news - commentary - research - analysis). I strongly suggest watching a stock's TOS intently during the same time of the trading day for several days in a row before initiating a position.

Remember, your goal is to figure out if a stock has buyers or sellers lurking in the shadows. The players on the exchange floor and big trading desks need someone to take the other side of their trades. Don't get ambushed.

Early next week, I'll wrap up this series with a look at the specialist limit order book and a discussion of the relative merits of limit and market orders.

|Specialists, Regulations, the NYSE and You, Part 4 |

|[pic] |

Most every trader and investor understands the basic concept of market orders and limit orders. In today's column, I'll peek beneath the surface and explore the informational content of your decision to buy or sell.

An Open and Shut Case

In response to both institutional and retail requests for more "transparency," the New York Stock Exchange decided last year to allow the public to finally see the specialist's book of orders, which had basically been privileged information since the exchange's inception some 200 years ago. The NYSE OpenBook is a real-time listing of limit orders posted in the specialist's order book for each stock. The data are available through a number of vendors such as Bloomberg, Reuters and ILX.

Professional traders who are affiliated with a broker/dealer generally have access to OpenBook. Although it hasn't yet happened, I'd venture to guess that Schwab, Fidelity and other brokerages with "active trader" clientele will offer OpenBook in the future -- much the same way that they now offer Nasdaq Level II quotes.

Sky's the Limit?

On the surface, limit orders appear straightforward. However, there's a critically important "story behind the story" that the vast majority of traders never even take into consideration. The truth is that every time you enter a limit order, you are effectively giving other market participants a free call or put option.

Think about it: If you put in a limit order to buy 1,000 XYZ at $25, haven't you given someone else a free chance to theoretically buy up to 1,000 shares slightly higher than $25 with just a few cents' risk? In actuality, the real risk is not the few cents above $25 that someone might pay, but rather the possibility that you'll cancel your bid if the stock starts dropping, leaving the person who bought ahead of you in a potentially compromising position. If any trader (including a floor trader) does what I just described, it is not front-running.

A specialist could also buy ahead of a limit order, but only passively. In other words, the specialist could respond to a newly arriving sell order by paying above $25 if no other buyers are willing to pay above $25. That is known as "price improvement" for the seller, because he or she receives a price that's better than the posted $25 bid.

There are also very strict rules about a specialist selling out of a long position by hitting limit-order bids. So the specialist probably won't be involved in cutting ahead of an order on OpenBook, but every other trader on the planet is free to do so.

Stop That!

Certain types of information do not appear on OpenBook -- specifically, stop orders and contingency orders (such as all-or-none orders).

It turns out that stop orders, which are always known to the specialist, are a source of valuable short-term information. Traders are all looking at the same Time of Sales, or TOS, data and tend to arrive at similar conclusions about near-term market activity. Short-term traders often have a herding instinct and consistently use obvious numbers for their stop limits.

For example, let's say that the indices are in an uptrend and stock XYZ is showing $24.90 by $25, 2,500 shares by 10,000 shares. Suddenly, buyers start paying $25 and the 10,000 for sale disappear. Now the market immediately goes $25 bid for another 10,000 shares. Guess what every daytrader in America who's long is about to do? That's right: They put in sell-stop orders at $25 or a few cents below.

Good Grief!

The thought pattern is, "It looks like there's enough buy interest to propel the stock higher. However, if the person who was buying at $25 gets completed at that price and then walks away, I don't want to be left holding the bag." Eminently logical, except for one thing: The floor broker who has the buy order -- and the specialist -- know that they can collect stock at the desired price of $25 by simply reducing their bid or temporarily pulling it altogether.

This is conventionally known as setting-off stops, and it's extremely common, not only in equities but also in the futures pits, where technical traders also tend to congregate their stop orders at obvious chart prices. Much as the Peanuts comic-strip character Lucy pretends to placehold the football and then takes it away just as Charlie Brown is about to kick it, traders who think they're poised for a profit end up with nothing but a loss and a sore butt.

To sum it up, the positive aspect of placing a limit order is that your execution price is known in advance. Of course, there's always a chance of not receiving any execution at all, if you put your limit price unreasonably far away from the current market. But for many investors and traders with an intermediate- or longer-term time horizon, this type of order placement makes sense.

Market orders generally provide immediate results, but you end up paying for it because your execution price may be above or below the prevailing bid/offer, depending on how many others are simultaneously placing orders in the same direction that you are.

I've found I do better by keeping a stop limit in my head and then only revealing it to the limit-order book at the last possible moment. And of course, I don't pick stop-limit prices that I think other traders are also using.

Later this week, I'll wrap up this series with some additional thoughts and conclusions. Judging from the dozens of emails I've received, there's apparently a real need for elucidation on the subject of market microstructure. I'll reply to all of your comments and questions to the best of my ability.

|Specialists, Regulations, the NYSE and You, Part 5 |

In this part of my series on specialists, I'd like to note the concept of a liquidity trade vs. an informational trade. A liquidity trade is typically done in a passive way, for reasons other than implementing a brand-new idea. An example of this might be an institution that is adding proportionately to its current holdings because it's just received a new flow of cash.

What's the 411?

Informational trades are initiated by a market participant with the specific intent of profiting from a viewpoint. The time frame on an informational trade can range from less than a minute (such as a perceived supply/demand imbalance) to years (such as a value player looking to accumulate a distressed stock at a perceived bargain price). Informational traders have an incentive to disguise their orders for obvious reasons. This is an entire topic in itself, which I'll cover in a future column.

Why is this distinction important? There are times when you may be able to locate and take advantage of a liquidity order. Under certain conditions, stocks trade to size, not away from it. While no technique is foolproof, I have found this to be particularly true on days when the indices are clearly positive or clearly negative. When the market is up, a large offer on the OpenBook could be a liquidity trade and not an all-day seller. When the size of the offer is a bit too much for smaller players to digest, the stock might lag behind the indices. Eventually, a big buyer or buyers will appear and take that offer. Most traders are too impatient to wait around the hour or two that it might take for this scenario to develop, because they see so many other stocks jumping. Of course, simply reverse the logic in a down market and a stock showing a big bid.

This type of situation may create an opportunity for you to use patience to your advantage. I've found that one patient trade of this type can be far more profitable than chasing other stocks that have already made their move.

As mentioned in Part 4, I favor using mental stop limits and then putting them into action at the last possible moment. I've used market orders on occasion, but my personal experience is that the use of market orders is a sign that I didn't think through the trade in the first place. I'm overleveraged either emotionally or financially (or both) and need to sell part or all of the position to clear my head, or because I misunderstood the action in the stock and it's not giving me a chance to exit.

Every Day I Write the Book

Caution: The limit order book may be subject to gamesmanship by anyone -- not just floor personnel. An upstairs trader who wants to temporarily jack up a stock could theoretically enter several buy orders at prices right below the quoted bid, with the intent of having others see that information on the OpenBook and try to jump in quickly. Then the game player could sell off his stock at higher prices and cancel his lowball bids. The reverse situation occurs when a trader wants to accumulate stock or cover a short.

While this pattern of bids and offers being pulled and reappearing could be considered manipulation and therefore be subject to disciplinary action, it would be unfair to penalize the vast majority of traders who are legitimately entering and canceling orders in response to changing market conditions. It is also somewhat risky from a P&L standpoint for off-floor traders to employ these tactics, because they're not privy to floor broker and specialist chatter.

House of Games

Equities trading contains elements of chess and poker. In a regulation poker game, everyone starts with the same amount of chips. In fact, poker couldn't exist without that one simple rule. Imagine buying into a game with $100, while your opponents are all sitting with an initial stake of $5,000. No matter how shrewdly you play each hand, the competition has the constant option of raising the limit until you finally break. The same premise applies to equity markets, especially in the context of short-term trading.

Recall my example of a specialist shading the quote to show a big offer. The idea is to force the hand of long positions with no staying power, much as a card player with a bigger stack of chips forces the smaller players to fold a hand. It's easy to be cynical and say the deck is stacked, but I'd make two counterpoints here: One, absolutely nothing illegal is going on (occasional isolated instances notwithstanding), and two, forewarned is forearmed.

In the same column, I explained that the big players (specialist and floor brokers) have orders that need to be filled, and by definition, someone has to be coerced into taking the other side of the trade. Determining whether there are buyers or sellers around in a particular stock is a probability game. Your goal is to end up on the correct side of the action, or at the very least avoid becoming fodder for the big institutional orders.

Searching for Bobby Fischer

The specialist and floor brokers are professionals who compete just as hard on their floor as any NBA basketball player does on the hardwood. In fact, the financial markets are a rare venue, where amateurs and pros are permitted to square off on the same turf.

Think of it this way: You can't expect to beat a Grandmaster chess champion at his or her own game. However, if you study the rules and understand basic strategy, you can make individual moves that will build up both your competency and confidence.

In this series of columns, I have touched on many aspects of listed trading that don't normally get coverage in trading books or the financial media. Although its recent internal investigation has drawn more media attention to the New York Stock Exchange, the vast majority of activities I've been discussing are perfectly legal. It's a function of the way our market system is structured.

The NYSE's competitive position is engendered by the advantage of physical access to verbal supply/demand information at the specialist post. Whether this is a monopoly or fair play as compared to the ECNs is the subject of much debate, and I'll address that another time. For now, the best we can do as traders is to understand current market structure and strategize within those parameters.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download