Executing our stock and call option trades is fast and efficient. But what actually goes on behind the scenes after we enter market or limit orders?

Once we type our order to the online discount broker there are a series of events that take place terminating in the successful execution of the trade. Here’s how it works:

1- We place our trade order with our online discount broker.

2- The broker then utilizes an electronic routing system to send the order to a market maker like Citi, UBS and others.

3- The market maker pays our discount broker a fee for this market flow, about  $0.01 or $0.10 for the 100 shares.

4- The actual shares can come from one of several sources:

  • Internalization– from the market makers own inventory
  • The major exchanges like the NYSE and Nasdaq
  • Dark Pools like Liquidnet- A dark pool (or dark pool of liquidity) is a private electronic transaction network, typically maintained by major banks and securities companies, where stocks are bought and sold by clients of those companies. Because the matching of buyer and seller is done entirely within the control of the bank, the bid, offer and sale prices are not published to exchanges (such as the NYSE). Dark pool operators have the ability to route orders either to an exchange or to their own private network, depending on availability, pricing and client preference. Ironically, before computers took over the floor of the NYSE, there was a popular saying relating to dark pools: The NYSE was the biggest and most efficient dark pool the markets have ever seen or will see, i.e. when you gave your order to a broker it was essentially dark because he wouldn’t just go into the crowd and announce “a million shares of BCI at the market”  because the market would move on him…he kept a portion of the order details (i.e. size) in his back pocket and “worked” the order to get the best price or execution.  Real people on floor, not computers, are still significant players for executing large blocks and especially for setting the opening prices…the majority of NYSE order flow comes at open and close because the prices are most accurate.
  • *Remain short the stock and look to buy it back at a lower price. This is where they make their money.

Market Makers Profit- The Math:

Let’s say the Designated Market Maker (DMM) sells us a stock short @ $30.10 and buys it a few seconds later for $30.09 for a profit of $.01 per share or $1.00 for 100 shares. Since the DMM paid our online discount broker $0.10 for market flow and garnered $1 in profit, that’s a $0.90 profit for the transaction. It may seem like a mere bag of shells on first blush but do this millions of times per day and it becomes an extremely lucrative occupation.

My day on the floor of the New York Stock Exchange:

I was fortunate to receive an invitation to tour the floor of the NYSE in 2010 and speak with some of the market makers. Here I am with my son Craig mingling with the one percenters:

On the floor of the NYSE

 

Dark pools update:

Speaking of dark pools, NYSE Euronext and Nasdq OMX Group, Inc. the largest owners of American stock exchanges are pressuring Congress to alter legislation that is causing stock orders to leave public venues in favor of broker-run markets like dark pools and brokers themselves. About one third of US equity volume has traded away from exchanges this year while dark pools have accounted for 13.6% of US equity volume this past April. The argument against dark pools are:

  • Too much fragmentation and “darkness” can cause investors to lose confidence and leave the markets
  • Exchanges are at a disadvantage since they must publish their rules and are required to seek SEC approval for alterations whereas dark pools are not
  • Dark pools can allow users to participate with or avoid certain types of participants whereas exchanges cannot
  • Excessive fragmentation and increased need for technology can create more risk as seen in the “flash crash” on May 6, 2010

Dark pools and brokers will argue that the increase in market liquidity and the positive impact of competition are benefits for all those who participate in market activities. Contrary to the way things transpired in the past, the SEC appears to be on top of these rapidly-changing market platforms.

 Market tone:

A plan drafted to aid eurozone banks resulted in a strong finish to the week and quarter. Economic reports continue to imply a sluggish economic recovery:

  • Consumer confidence in June (62) declined for the 5th time in the past 6 months
  • Real GDP growth for the 1st quarter, 2012 came in at an annualized rate of 1.9% compared to 3% for the 4th quarter, 2011
  • Analysts are projecting an increase in consumer spending due to falling prices at the gas pumps
  • Sales of new single-family homes rose by 369,000 in May compared to the 346,000 expected. This was the strongest increase in two years
  • Housing inventory is at its lowest point since before the crash in 2008
  • Durable goods orders in May came in at a strong +1.1% while 0.4% was expected

For the week, the S&P 500 rose by 2% for a year-to-date return of 9.5% including dividends.

A 6-month comparison chart of the 3 major indexes plus the Nasdaq 100 (QQQ) shows the market generally uptrending for the year so far but in a volatile manner:

6-month comparison chart for 2012

I am looking forward to the long-term ‘party” we will all have if and when Eurozone concerns and housing issues continue to improve and the jobs numbers  turn positive. It could happen!

Summary:

IBD: Confirmed uptrend

BCI: Cautiously bullish selling predominantly in-the-money strikes.

My best to all,

Alan ([email protected])

www.thebluecollarinvestor.com