Seeing all those orders gives Knight what Mr. Pasternak, its chief executive, calls an "informational advantage": exclusive intelligence on which it can trade for its own profit.
This is the author's conclusion and it is totally incorrect.
"We're smarter than the market in aggregate and we're able therefore to make a determination whether the stock will go up or down," he says.
This is Pasternak's opinion and if he thinks that's true, he's deluding himself. I call this the "myth of the insider".
All this success is a magnet for both admiration and criticism. "They've built a great firm in terms of automating processes and serving people," says Bill Burnham of venture-capital firm Softbank Capital Partners. But, he complains, the people at Knight are "taking information about retail customers' intentions to trade and using that information to improve their own proprietary trading profit, at the expense of their customers and of other participants in the market."
This is Birnham's opinion. It is illegal to do this and even if you try, you can't benefit. A trader whose job is to get on the other side of the public makes money by the excesses of the public action. If they try to do anything creative like using privy information to take risk positions as principal they move from the inherent positive expected return of making a market to the negative expected return of using information to beat the market they make.
The subsequent explosion in online trading would have been enough to make Knight a success. But something else crucial happened. Nasdaq market makers historically profited from the spread between the bid price at which they bought stocks from customers and the offer price at which they sold. But in 1997, a federal probe of dealers' practices resulted in new rules that squeezed these spreads. The squeeze was made tighter still when stocks began trading in sixteenths instead of eighths.
The three sentences above refer to disjoint events and issues. It's the author's attempt at yellow dog journalism to tie them together for impact. If Knight only profited by the spread they would have a hard time breaking even. Knight makes money when the public order flow is disbalanced and Knight is called to fill orders substantially and progressively away from the instantaneous market. These excursions from equilibrium require proprietor's capital. Filling at the spread usually generates no net end of day clearance demand for loanable funds.
With profitability collapsing, many dealers stopped making markets and sent their Nasdaq orders to "wholesalers" such as Knight or Schwab Capital Markets, which make markets in thousands of stocks for other brokers. Such firms, Mr. Pasternak told investors in the 1998 prospectus to Knight/Trimark's initial public offering, would no longer profit primarily on spreads. Rather, they would "take advantage of the profit opportunities represented by each trade."
This is another attempt by the author to mislead by implication. The profit opportunities occur because of the excesses of the public action, not because the market making firm sets up an environment to instigate public excess.
As Mr. Burnham puts it, "Nasdaq has been transformed from a market where people make money off spreads to one where people make money off information.
Birnham again is deluding himself. He's a beginner in the biz and he talks just like one. There is no information in the order flow that can be used by taking extra risk to benefit. Doing anything outside of getting on the other side of the public action is taking extra risk which isn't compensated over time with extra return.
When the market was so much more fragmented, it was hard to be right. But when you have 30% of the order flow, you can make some damn good guesses."
Thanks for confirming what I said above.
Mr. Pasternak concurs.
Mr. Pasternak will not last long if he believes what he's stated.
Computers automatically fill the vast majority of orders Knight is charged with executing, leaving most of its 393 traders free to try to take advantage of the information these orders reveal about the market.
This is the age old quest for riskless return. No one has ever succeeded and Wall Street is strewn with the corpses of the silent victims who have tried to prove to the contrary. They were trying to prove the validity of a falsity.
The trader ethic begins with Mr. Pasternak, who mixes the jargon of financial theory with the expletives of a trader. Seated in a vast trading room in a Jersey City, N.J., tower overlooking lower Manhattan, the 46-year-old CEO explains that Knight profits by combining many bits of information about market trends with calculated risks.
All part of the negative expected return since the risk they incur is calculated and therefore is presumed to be zero or managed.
Oracles and Eggheads
One morning last summer, Oracle was trading at $34. What would happen if it fell a point? Mr. Pasternak opened his file of limit orders, those that can be executed only if the stock hits a price the customer specifies. There were 13,000 shares' worth of buy orders between $33 and $34, but orders to sell 2 1/2 times that many shares between $34 and $35. Knowing of this selling pressure, Mr. Pasternak would hesitate to buy Oracle, and he might even sell it short, betting on a decline.
The number of people who have tried to use the book to benefit is countless, and yet, all have failed on balance. The NYSE specialist learns, if they wish to survive, to ignore the book and obey what the market and rules require. The second they get creative their expected return falls, and if they persist, they will go broke. It is tempting to use such pseudo information. You have to discipline yourself not to do so. Those that can't control themselves fail and there are many who fail. They always blame market conditions for their failures. All they had to do was to only do their job.
The move looked smart as the stock weakened slightly just after the opening. "I was informationally advantaged," Mr. Pasternak says.
The guy gambled and won. How can he conclude he had any advantage? When the trader wins, you hear all about how it was due to skill. When the trader loses, you don't hear about it.
But then it turned dicey. A second wave of buyers sent Egghead shares climbing. Knight at one point had a paper loss of $250,000. But the stock slid sharply by the end of the day. Knight made a profit of $100,000.
Knight was lucky on this transaction. So what? If actions arise from responding to the public, then on-balance the actions will yield a return. If they arise by speculating on "information", in time they will yield a loss. This is the experience of hundreds of firms over hundreds of years of market history. The operators of the past were incomparably better than the hacks of this era. With all their ability none succeeded. The only traders who trade taking risk and suceed are the ones who quit when they are providentially ahead. Almost none do. They all quit when they go bust which in 99% of the cases occurs within 5 years. Making a market is not trading.
But what about small investors? Softbank's Mr. Burnham says that while buyers got Egghead stock at the opening price, as promised, perhaps that opening price would have been lower if not for Mr. Pasternak's heavy pre-opening buying. "Kenny wouldn't have bought those 50,000 shares if he didn't know they wanted to trade at the open," Mr. Burnham says. "He used their own information against them."
This claim is absurd or incoherent. It begs itself. Petitio principii. If it were possible to assert its truth, Pasternak is going to jail, but fortunately for him, it is gibberish cooked to sound like macho big talk.
Knight promises to execute, at the day's opening price, the first 250,000 shares' worth of buy orders sent to it before the opening bell. But other traders say that before the opening, wholesalers -- and Knight in particular -- regularly use aggressive trading tactics to push a stock up or down to favor the positions they will have to take when they execute the orders.
This is strictly prohibited and I mean strictly since it constitues a manipulation pool reminiscent of the '20s. Knight does not use any such tactics. They don't need to use anything. Order imbalance is being caused by the public build-up of orders overnight. What does Knight need to do? They don't "push" anything, but they do have to make sure they transact at sufficiently away levels to protect themselves against loss. Nothing illegal or undesirable about that because the only way to cool the public excesses is by printing way away trades. No one will stand in the way of the lunatic driven public train and that isn't the market maker's function anyway. Maintaining a fair and orderly market doesn't mean bailing out the stupidity of the public's greed.
All the wholesaler "cares about is getting the stock up to a level where he can fill all his orders profitably," says Matthew Johnson, head of Nasdaq trading at Lehman Brothers. But "where it opens is not necessarily in the best interest of their customers."
It isn't necessarily in the interest of anyone. It depends upon how you are positioned. This quote is another attempt by the author to stir it up.
In normal markets, the highest bid (to buy) is just below the lowest offer (to sell). Yet it's not uncommon, traders say, for Knight to bid more for a stock than the lowest offer to sell it, and to offer to sell a stock for less than the highest bid to buy it -- an anomalous situation known as "locking" or "crossing" a market. This anomaly leaves the best-priced order unfilled. But it forces the market in the direction the firm wants it go.
It certaintly doesn't force the market anywhere. The author talks as though Knight is the only market maker or that Knight has greater resources than all the other players or that Knight is acting as principal. There isn't anything anomalous about a cross. So what if more is offered than bid? How does it necessarily "leave the best-priced order unfilled"? And so what if it does? If Knight has more volume to bid than offer should they cease their agency obligation and only bid to offer? Apparently the author doesn't realize that it is illegal for market makers as principals to bid or offer in front of the best agency bid or offer. Each firm must get in line at every level based on time priority. (So much for the mythical "walk" you hear from patzers)
Nasdaq restricts crossing during the day but permits it before the opening.
This is non sequitur and like the author's other comments taken out of context for ulterior motives.
"It's not unusual to see the large wholesale firms leading the pack on some of these locked and crossed markets on most openings, and clearly Knight is the name that's pre-eminent," says Patrick Ryan, president of Ryan, Lee & Co., a small brokerage firm in Washington, D.C. Still, he says the problem results more from the behavior of Knight's end-customers than from Knight itself.
This paragraph is an attempt to gain credibility by turning the reports toward the believable. You redact valid statements and sprinkle them appropriately so that the ulterior motive is advanced.
If Knight is "sitting there with unsolicited orders from a group of gamblers -- who figure 'P.T. Barnum was right, if I pay $90, someone will pay $92' -- clearly it's buyer beware."
So where isn't it buyer beware? Where government fixes prices to protect?
Schwab Capital Markets President Lon Gorman says there was an "irrationality" in the market that day, and he has since led an investor-education campaign "to make sure that never happens again." Speaking more generally of the criticism of wholesalers, he says: "The notion that there's something going on in the back room, that you get an execution that's inferior, is totally bogus."
Another credibility quote.
As for Knight, Mr. Pasternak says it loses money almost every morning because of its guarantee to fill orders at the opening price. That crazy morning, he notes, the buy orders that market makers had to fill at the opening bell exceeded all the shares in the IPO. Mr. Pasternak says he will occasionally place a bid higher than the offer "if I don't like how the market is pricing."
This is trained monkeyism and doomed. It shows Paternak is a creature of the era. When the era ends, so does the creature. Given the extraordinary nature of the era, the ending will certainly be unique in history. How about rationed demand for an original ending?
Knight promises online brokerage firms that when it gets an order, it will automatically execute it at the best price anywhere, even if it's not Knight's quote. To execute buy orders, for example, the firm buys shares and keeps them briefly in inventory, risking a price decline before it gets rid of them.
This admission makes every point I've made and refutes the nonsensical claims made earlier by these big talkers. You'd think a guy 46 and now effectively wealthy would know better than to be shooting his mouth off which easily could send him directly to jail without going through "Go".
Christopher Vu of Houston ...
Brown says Mr. Vu has no case...
Brown is right and Vu is initiating a false suit, because Vu is attempting to extort for justified loss. The public always believes there was a conspiratorial reason for their greed having failed. The previous responses to your post have all been of this nature. They read the article and were moved by the author in the direction the author wanted to move them. You now know that ulterior motive. It isn't hard to conclude that those four responders have been losing. |
