Investing - Part V

Market Mechanics

OK, time for part five of my four part series of investing tips. This one is going to focus on market mechanics or how trading actually happens on the stock market (and to a lesser degree on the options markets).

First thing to realize is that there are two distinct stock markets: the exchange based markets and the NASDAQ. There are some exchange-listed stocks that can trade on the NASDAQ, but NASDAQ stocks will not trade on an exchange.

How can we tell where a particular stock trades? It's actually pretty easy in most cases. If the symbol has three or fewer letters, like IBM (International Business Machines), KO (Coca-Cola), or F (Ford Motor Company) it will trade on one of the exchanges with its primary exchange, or major market, being either the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE). The concept of the major market will be very important, as we will soon see.

If a stock symbol has 4 or more letters, that indicates that it trades on the NASDAQ or the Over the Counter Bulletin Boards (OTCBB) markets. With NASDAQ or OTCBB issues there is no major market. These are actually networks of interconnected computers. The structure of the NASDAQ and OTCBB will also play an important role in determining how things work out for you.

There are a few oddball exchange listed stocks out there that appear to have four letters, like Agere Class A, which is listed as AGR.A. Most systems drop the "." In doing your pre-purchase analysis, it is always a good idea to confirm the market on which the stock trades.

But why is it important? After all, you place your trade and some computer matches it with someone on the other side of the transaction and off you go, right?

Not exactly.

Let's say you place a limit order to buy 100 shares of XYZ at a limit of $50. With the symbol XYZ, we know it is an exchange-listed stock. For arguments sake, let's say the major market is the NYSE, not the ASE.

So you call your broker or go online and place your trade. Now what?

Chances are, your order will not go to the NYSE, it will probably go to one of the regional exchanges, like the Boston, the Midwest or the Pacific. Brokerage firms do this because the cost of executing the trade on a regional exchange is usually much, much less than running it on the Big Board. It can also have benefits for the client.

When you place your order, let's say the quote line looked like this: 50-50.50 20x40. What does this mean? First we need to identify what those numbers mean. The first number is the bid, or the most someone is willing to pay for the stock at the moment. The second number is the ask, or the lowest price that someone is willing to sell the stock for. The third and fourth numbers are the size, or how many shares are available at each price (expressed in units of 100, so in the example there are 2000 shares available at the bid price and 4000 available at the ask price).

So you place your order. If it went to the NYSE and no trades occurred the quote would become 50-50.50 21x40. Your one hundred-share offer to buy is listed on the bid and you take your place in line on the order book.

Now let's say an order comes in to from someone else to sell 2000 shares at $50. In that case the market specialist would fill the 2000 shares ahead of yours and the quote would become 50-50.50 1x40, with you being the first hundred shares in line when the next sell order comes in.

If the 2000 shares traded and the price then started to move up, you could very well see a trade at your price, after you placed your order and you may not get your order filled. You needed to have 2100 shares trade before you would be assured of a fill.

Now what happens if your order goes out to say the Pacific Stock Exchange? Does it get handled differently?

A little differently. The idea of major market protection says that you can't do any worse than if you had been routed to the major market. So once 2100 shares traded on the Big Board, you would be "due a fill." However, the PSE will also have it's own quote, which may look like this: 50-51 1x10 when you place your order. In that case, if just 200 shares trade on the PSE, you will get your fill. So you can sometimes get a quicker fill on a regional exchange, but you will never do worse than if you had been routed to the NYSE.

The big thing to remember is that the regionals must honor the quotes and fills of the major market. The major market, however, is not bound to (and I never saw it) honor the quotes of the regionals.

So how do the NASDAQ and OTCBB differ from the exchange system? Doesn't the fact that the NASDAQ is computerized make it more efficient?

Actually not. The rules for the being assured of fills on the NASDAQ is vastly different than that on the exchanges.

On the NASDAQ, instead of the specialist in the trading post on the exchange floor brokering the deals, the market maker actually takes the other side of the trade with you. So lets look at how a trade might work on the NASDAQ.

Let's say that you place an order to sell 100 shares of XYZA at $49. You send your order into your broker who is then going to send it out to the market maker. Your broker chooses to send your order over to Prudential's market maker.

The quote on the NASDAQ National Market system was showing 48.25-49 2x200 at the time you place the order. Now let's say an order for 25,000 shares goes off at 49.00. Question is, are you due a fill?

Depends. If the sale of 25,000 happened at Prudential also, then you would probably be able to make an argument. If the 25,000 shares executed over at Merrill Lynch's market maker, then you would not be due. Market makers are not required to make orders available to the entire market. Internal matching between two orders at the market maker is allowed.

In fact, you could see trades executing at other market makers at prices greater than 49, and you still would not be due. Until the bid price hits 49, you really don't have any grounds for complaint on a NASDAQ stock. There is no centralized order book; there is no major market. You are not due a fill until the bid price comes up to your asking price.

Now some of the more advanced traders may be familiar with the Manning rule that states that a market maker cannot trade for their house account before trading a customer's order. But there are quite a few exceptions to the Manning rule that makes enforcement difficult. I saw a few trades filled because of Manning rule oversights, but not too many.

And when we look at the OTCBB and the pink sheets, it gets even more wild. There are no protections in these markets. Quotes are not firm and trades are almost always executed manually, though phone calls between different market makers (yes, they do still use the telephone for them).

Rule #1 of trading the Bulletin Board or pink sheets is never use a market order. This is one of the few times that I will say that anything is absolute in the markets. Never use a market order in these two markets (I once saw a person get a fill at less than 1/3 the quoted price on a pink sheet market order).

The OTCBB and the pink sheets are still the Wild West of the stock market. Anything goes and just about anything can (and will) happen. The oversight in these markets is weak at best and manipulation runs rampant. Most of the "hot tips" and "great opportunities" that are pitched at you will be on one of these two markets. Only trade with limits in the OCTBB and pink sheets. Also make sure that you know exactly what you're getting in to. Opportunity is there for the knowledgeable, disciplined investor; danger abounds for the inexperienced or unknowledgeable.

Most trades go off without a hitch or problem. Even when I was working with the hyperactive traders, I would have maybe two actual trade disputes per month - maybe two. But when a fill was corrected, it was usually very profitable for the client. I have seen corrections in excess of $2500 made due to an exchange or market maker oversight.

Knowing how trading actually occurs can sometimes save you some money. It can also help you to spot potential opportunity once you know how to read the quote lines quickly (you can follow the size and identify support and resistance levels along with potential price trend reversals - all very, very short term technicals - but I have seen people profitable trade them. Beware though, trying to do this is very, very risky. It requires putting up a huge amount of capital for a very short time to hopefully pick up a very small gain).

Most of all, it will make you more knowledgeable, which is really what is needed in order to be successful in the market.

To get to the other sections:

Part I - Fundamental Analysis

Part II - Technical Analysis

Part III - Options

Part IV - The Economy and The Market

Part VI - Mutual Funds

Part VII - Asset Allocation

Part VIII - Bonds