Trading Places

posted in: Writing | 0

David R. Evanson

Privately Published, Spring, 1995

The US markets are the best place in the world to buy and sell securities. Much of this good fortune can be traced to the diversity of the securities markets. The many instruments which are traded, and the variety of ways and places in which they are traded make the US markets the deepest, most liquid and most efficient in the world. For individual investors this is good news because it means they can participate in the markets, and profit as handsomely as even the largest institutional investors.

Individuals who buy and sell securities on their own eventually come face to face with the exchanges, most notably the New York and American, and the Nasdaq Stock Market. Informed investing requires an understanding of how these markets work, and the major differences between them.

The Great Divide
The great divide among stock markets centers around the concept of an auction versus an electronic marketplace. The New York and American stock exchanges are auction markets, while the Nasdaq Stock Market is an electronic market. There is no easy answer as to which market is better. But to understand the differences, consider, in summary, how an order might flow through each.

Suppose the order is for a NYSE-listed stock such as General Motors. The retail stockbroker who receives it immediately communicates the order to the firmzzs floor broker who is physically located on the trading floor of the New York Stock Exchange. If the order is 1,200 shares or less it will be completed automatically with the NYSEzzs designated order turnaround (or DOT) system. But for larger orders, the broker then walks, (and in many cases runs) to the specialist post where GM stock is traded. A specialist is a brokerzzs broker, and keeps a list of unfilled buy and sell orders for specific stocks which are assigned to the specialist by the exchange. While the specialist can match buyer with seller, many times brokers who meet at the specialistzzs post will simply complete a trade between themselves. Whether the order for the GM stock is filled by another broker or the specialist, the key point is that the buyer and seller meet face to face on the trading floor. Once the trade is complete, the floor broker communicates the results back to the retail stockbroker, who then informs the investor that he or she is now the proud owner of GM stock.

But what if the order was for Microsoft, which happens to trade on the Nasdaq Stock Market? Now the broker will route the order to the firmzzs trading room instead of to the floor of an exchange. If the brokerzzs firm happens to be one of the many market makers in Microsoft stock, that is, fills the role of a dealer by buying and selling shares of the company, the brokerzzs firm will execute or fill the order. If the firm is not a market maker, it will shop for the best price on the stock among the several competing market makers who have posted their prices on Nasadaqzzs electronic network of computer terminals. Once the best price is found, the order can be executed. Note however, that buyer and seller never physically meet during the transaction.

Strength, Weaknesses/Opportunities, Threats
Screen-based trading systems such as Nasdaq offer investors a significant advantage, according to many experts, because the competition among market makers which naturally occurs as they strive to generate orders, tends to produce the best possible price for a given stock. On the other hand, auction systems bring together the maximum number of buyers and the maximum number of sellers who can set the price of a stock without any influence from a dealer. In the minds of many investment professionals, this is the best way to discover and establish the true price of a stock.

Historically, the electronic marketplace has been criticized for excessively wide spreads — or spreads that seem wider than those on stock exchanges. The spread is the difference between the “bid” and “ask” price on a share of stock. The effect of this spread can be illustrated by the loss an investor would experience if he or she bought a stock on the “ask” of say $15.25 and then immediately sold it at the prevailing “bid” of $15.00 — producing a “haircut” of some $0.25 on each share. While few investors buy and immediately sell stock, the width of the spread has a measurable impact on their eventual gain or loss.

Regarding these criticisms, spreads on the Nasdaq Stock market are very often as narrow as those on an exchange. And where they are wider itzzs often because the companies at hand are smaller and thinly traded. These kind of companies present more risk not just for the investor, but for the market maker as well.

On the other hand, many investment professionals speculate that the New York Stock Exchange, and the auction system at large may represent a way of doing business that is obsolete. When the exchange began under a buttonwood tree in lower Manhattan, a centralized place was the only practical way to bring together a buyer and seller. But with telecommunications, the need for a central floor has all but disappeared. Indeed, a lament often heard among traders is that while they would like to drive a horse and buggy, the fact is that it cannot pull out in todayzzs traffic.

The problem of a centralized floor is the many accepted ways of doing business which circumvent it. Specifically, institutional investors often trade large blocks of stocks after hours, or participate in proprietary trading networks. However, a question arises: Is the individual investor who buys through the exchange paying the right price for the stock?

No system of trading stocks is perfect, and each has some advantages over the other. Itzzs more important to understand the risks and opportunities of the market where you are doing business, rather than to avoid one or the other altogether because of incomplete, or incorrect information about how they work and what they have to offer.

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Now that youzzve gotten an orientation on some of the basic differences between the markets where securities are traded, be sure to read this column next month which will provide detail on one of several major investment product categories.