Quiz
CHAPTER 4 The Playing Fields 53
certain stocks of its choice. Making a market means being ready to buy or sell the stock whenever the Nasdaq is open. Being ready to buy or sell simply means having a bid (offer to buy) or an ask (offer to sell) price in the market at all times. Either of these prices or both could be substantially away from the current market price.
Besides being a market-maker system, Nasdaq is a multiple-market-maker sys- tem compared with the one stock-one specialist NYSE system. For a stock to be listed on Nasdaq, it must have at least five market makers who are prepared to make a market in its stock, plus it must meet certain financial and reporting require- ments. The fact that there are multiple market makers and that they are not located in a single location, like an exchange floor, adds to chaos (read volatility here). Ad- ditionally, the market makers have no idea what the other market makers—and there can be a whole lot more than five market makers for an active, popular stock—hold in terms of orders for their customers and for their firm’s account.
These firms are broker-dealers, meaning that they broker trades for customers and deal in stocks for their own account. None of them possesses anywhere near the in- formation that a specialists has.
Think back to the poker game analogy for a moment. The specialist, as dealer, knew what every player held in his or her hand. On the Nasdaq, it is a game where none of the players has any inkling as to what cards (orders) are held by which
other player. In the true spirit of the game of poker, they play cutthroat. Every mar- ket maker knows only what is in its own hand, meaning its orders to buy and sell.
You might be wondering, if the market-making broker-dealers are on both sides of the market, how do they control what they buy and sell? Price is the answer. Take a moment to study the simulated computer screen in Figure 4-1. The columns on the left as you face it have all the bids, or offers to buy stock. The first column has the symbol of the market maker, followed by the number of shares and how much it is willing to buy the stock for. On line 1 you see that GSCO (Goldman Sachs & Co.) bids 24.50 for 1,000 shares. On the right side, you see that MLCO (Merrill Lynch &
Co.) is offering to sell the stock in question for $24.51 per share and wants to sell
Figure 4-1.
100 shares. The difference between the two prices is a penny and is the spread. The wider the spread, the more volatility there is in the market, which is another clue to judging the rate of volatility. A narrow spread means less volatility.
The best bid and ask is called the inside market. In the bid column are all the firms that want to buy the stock. If you want to buy something ahead of others, you offer the highest price. Therefore, the highest price offered is on top, and the prices descend the lower you go. On the right side are all the sellers showing their asking prices. This column is arranged in just the opposite way: The lowest price is at the top. If you wanted to buy something at the best price, it would be the lowest price.
Remember, stock shares are fungible, or all exactly alike, and can be freely inter- changed. A stock certificate for 100 shares of Dell Computer is just as valuable or worthless as any other certificate for 100 shares of Dell. A fungible commod- ity is required in order to make a market and to facilitate the speedy transfer of ownership, as in overnight, from one party to another without having to do any verification.
The large box at the top of this screen sums up the situation for WXYZ stock.
Here you find the current market price and change from the open, the amount of the last trade (100), the inside bid and ask, high, low, previous close, opening price, and the volume up to this moment for the current trading session.
What if you were a market maker and had to be on both sides of the market, but you only wanted to buy? You would raise the price at which you are willing to buy to a level higher than or matching the highest bid, or, as they say in the industry, you would be on the inside bid or you would be at the bid. You would then lower your ask price to put it at the bottom of the ask list. This puts you in a position to buy stock and to have a whole lot of other broker-dealers ahead of you to sell. If prices go down and you still do not want to sell, you just keep lowering your ask- ing or offering price. Once you have bought all the stock you wanted, you lower your bid, allowing other buyers to move ahead of you in line.
As you learn to read the bid and ask price tickers, you can see who really wants to get its hands on a lot of stock and who wants to dump it. This is done by watch- ing how fast prices change and how high or low volume moves. These two factors are also clues to the rate of volatility. Some day traders who have mastered this skill and never went any further in their trading education have made good livings from day-trading stocks—but the option trader has a long way to go.
The Nasdaq is a negotiated market, as opposed to the open outcry market of the floor-based exchanges, and thus carries an over-the-counter designation. The ne- gotiation occurs as the brokers constantly adjust their bid and ask prices to reflect what they or their customers are willing to pay or take for a stock. This market does not have a price cop, like the floor-based exchanges. Every market maker is on its own and is constantly competing with all the other brokerage firms and even some orders from individual traders via ECNs. Some ECNs, for example Archipelago,
CHAPTER 4 The Playing Fields 55
send orders to the Nasdaq system if they cannot fill the order from their or other ECNs’ book of orders.
Since all the orders appear on the Nasdaq trading screen and all the brokerage firms and traders have access to the Nasdaq screen, all the orders are transparent—
but you do not know what is behind each order. A broker-dealer may want to buy 10,000 shares of Dell, but does not want its competitors to know that it needs that much because they will drive the price higher (known as market impact cost). To avoid this, the B-D (broker-dealer) shows an order for 2,000. When that order is filled, another order for 1,500 shares is released. The B-D keeps feeding orders until all 10,000 shares needed for a customer are accumulated. While it is doing this, a sharp day trader spots this broker-dealer’s repeated orders. She jumps in and buys a thousand shares, riding the stock higher. The minute she spots the broker- dealer leaving the market, she sells her thousand shares for a half-dollar profit, or
$500. This may not seem like much, but the day trader’s objective is to make
$1,000 a day, and with 250 trading days a year, this means a gross of $250,000.
The day trader’s strategy is call “following the Ax.” To throw off the day traders who push prices higher, the primary buying broker-dealer, the Ax, jumps to the sell side of the market from time to time as a feint. This is all part of the poker game as played on Nasdaq, which adds to its high volatility.
Individual traders, working out of their home or office, can have access to the Nasdaq screen. It is available to them from their brokerage firm or via trading soft- ware programs for a monthly fee. Since anyone who wants access to this price in- formation can get it, Nasdaq is much more transparent than the floor-based exchanges. With the floor-based exchanges, all one gets is a stream of quotes with volume. You do not know what unfilled orders are in the specialist’s book. No one but the brokers who make up the crowd around a trading booth on an exchange floor can see who, meaning which firm, is aggressively buying or selling a partic- ular stock. All the public sees is the ticker tape below the screen on CNBC or some other source. Transparency can be very important for getting a feel for volatility on a specific stock, but this helps only very short-term traders.
Transparency can also result in confusion. On the Nasdaq system, thousands and thousands of people see who is placing orders for which stocks, the size of the orders, and the pricing. All these people in cyberspace are guessing and scheming how to outfox one another. This can lead to confusion and bizarre market moves.
The participants cannot see one another and read their body language the way floor traders do. Remote traders guess what is happening. If market-making/breaking news hits, they must react and react fast. No one is there to halt trading until they figure out what is going on and its impact on prices. On the Nasdaq, it goes boom!
Prices jump or plunge $10, $20, or more per share in minutes—only to recover if the news proves false.