Since You Asked

with Don Bright

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.

I’ve heard that my direct-access broker actually routes my trades through the firm. Can that be right? How is that direct access? — TCmac

I get this question a lot. Your order needs to go through the brokerage firm to verify that you have enough funds to cover the transaction, check for “pattern daytrader” compliance, and so forth. To get true direct access, the market participant must join an exchange or a proprietary trading firm. That way, your orders are covered by the broker–dealer directly, not your individual account. Hope this helps.

Don, you’ve been pretty quiet on some very disconcerting topics within our industry. I would like to hear your opinions on subpennying, transaction tax proposals, and flash trades.

I’ll address the transaction tax first. Imagine a trader who risks his capital while providing liquidity for the public and others. This trader may buy and sell 50,000 shares per day. If the average stock price was $50, then he would be selling $2.5 million worth of equities. A quarter of 1% “tax” would amount to $6,250. This is a total disaster, of course; the trader may be making or losing a few hundred dollars during that day, so this is a total deal breaker. I just don’t see this happening. Perhaps a minor per trade charge or something would work.

Now to subpennying. Here is an excerpt from an article written by Dennis Dick, one of my traders, who is also a Cfa:

The hidden cost of “sub-pennying”
Why are broker–dealers allowed to force other investors to pay the spread? Consider the following scenario: The ask price in security Xyz is publicly posted on the exchange at US$25. A trader places a limit order to buy 100 shares of this stock at the US$25 ask price. The execution price comes back at US$24.9999, a price improvement. The person offering the stock at US$25 remains unfilled.

What happened? Why did the person offering the stock at the best available price not get the fill? Because a broker–dealer or high-frequency algorithmic trader stepped in front of the US$25 seller and took the fill. This practice is known as “sub-pennying.” When decimalization took place in 2001, it was a common practice for traders and marketmakers to step in front of displayed orders by a penny. They did so to get to the front of the line for execution. The term “pennying” was coined for the practice.

In this example, someone stepped in front of the order not by a penny but by 1/100th of a penny, hence the term “subpennying.” Sticking with the initial scenario, the trader offering the stock at US$25 was part of the National Best Bid and Offer (Nbbo). The Nbbo for a stock consists of the highest-posted bid and the lowest-posted offer. It is the best publicly available market for the stock. In the example, the trader tried to buy the best-posted ask price but received a price improvement of US$0.0001. How did this happen? A broker–dealer is allowed to provide price improvement to its customers. In this example, the broker/dealer sold the stock at US$24.9999, providing the customer with a savings of $0.01 on the US$2,500 buy order. But the person offering US$25, the true liquidity provider, has not been filled. That investor is left holding the stock. Tough luck! Even though the buyer is left unscathed and actually received a better price, the outcome is not fair to the seller whose order was left unfilled. (To read the full article, go to www.stocktrading.com/subpenny.pdf.)

Now to flash order or “high-frequency” trading. We had an example of how these trade types happen as of this writing. Rambus (Rmbs) had a price drop of 30% and more, and trades were broken. I’m not saying anything was done wrong or illegally, but this excerpt of another article, again by Dennis Dick, details potential problems:

Hft market making may lead to a crash
Rambus (Rmbs) fell 30% today in a matter of five minutes. It immediately bounced back. The cause for this move was speculated as a trader with a “fat finger.” A trader simply messed up and sold too much stock accidentally, causing a swift and violent selloff. The trades were later deemed erroneous and busted by the exchange.

But what if the real cause wasn’t just a trader with a “fat finger,” accidentally selling too much stock? What if it was something more serious? I believe it is. I believe the real cause for this move is a major concern for our markets. The real cause may have been high-frequency market making gone bad. (To read the full story, go to www.stocktrading.com/HFT.htm.)

When we first joined the exchanges as market makers, we were called “HFTraders.” The buy & holders were the bread & butter of the industry. The Nyse volume was only about 50 million shares per day. The advent of derivatives naturally brought the “hedgies” (as we were known then on the options and futures floors), and the public speculators. The public could now bet with long options, with limited downside. This created a landslide of increased equity volume. So this new sector of investors or speculators became a bigger group overall.

And then there’s the loosening of regulations that allowed banks to become brokers and brokers to issue checking accounts. In the mid-20th century, the 1960s and the 1970s saw money market accounts being issued by banks. The 1980s saw the loosening of the Glass-Steagall Act, allowing up to 5% of banks revenues to come from investment banking, and onto the Bankers Trust decision increasing the amount. (There’s an interesting timeline that you may want to examine at www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html.)

All this expanded trading considerably. Then in the 1990s, with the small order execution system (Soes), everyone, bandits and busters alike, wanted to become a daytrader. Not a great move for the average investor, as we all know (or at least found out).

We lobbied to keep our traders as “off-floor” exchange members to be treated as professionals, and finally licensing was required (simply to make a distinction from retail traders). As always, from our trading floor days, we provided liquidity and took risks, hopefully making a profit from risk-taking.

We went from quarters to eighths to sixteenths to pennies. While many spouted gloom at each juncture, we simply adapted and proceeded.

At the point that technology creates a different bias, whether subpenny or routing, to either sell side or buy side, then the playing field has changed demonstrably.

I would prefer industry guidelines over governmental intervention, but the two have become so intertwined over the years, I will settle for anything that gives all market participants equality.

We should not have a two-tiered system. I speak as both a trader and a broker–dealer.

E-mail your questions for Don Bright to Editor@Traders.com, with the subject line
direct to “Don Bright Question.”

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