The risks of online trading
very good article follows:
BY MARK SCHWANHAUSSER
Mercury News Staff Writer
If you listen to the seductive advertising, all it takes to be a player on Wall Street is a computer, a modem and an online brokerage account.
Thanks to the Internet, torrents of financial information have become available, commissions have plunged, and the process of placing trades has become quicker than ever. It's so easy to profit, Discover Brokerage boasts in its advertisements, that tow-truck operators can afford their own islands. You've got to get wired in, says Fidelity.com, because ``every second counts.' And now you can haggle with the big pros after the markets normally close, by logging on with E*Trade and Datek.
But the reality is many investors have developed an exaggerated sense of power and control that belies the risks and costs of buying and selling stocks through online brokerages. Despite all the swaggering talk about how technology is leveling the playing field, the rules of the game remain fundamentally unchanged -- and the vast majority of investors remain outsiders looking in.
As powerful as technology is, it is but a tool. It is information, not know-how. It is changing who trades stocks and when, but it has not altered the basic function of the brokerages that cater to the vast majority of online investors: They take orders and transmit them to a stock exchange to be executed. Assuming the Internet hasn't crashed, you can speed your order to your brokerage. But it hasn't changed the way trades are prioritized and executed on the trading floor.
``A lot of people think, `I'm interacting with the actual stock market.' That's not true at all,' said Mike Shokouhi, spokesman for the Nasdaq stock market. ``All the Internet is doing is taking the place of a phone call. That's it.'
The hype over technology obscures the importance of understanding thoroughly how the markets work, how brokerages and dealers make money, and how to place orders strategically. Namely:
Brokerages do not actually execute the trades; they hand them off to ``dealers' whose own interests frequently are at odds with those of the individual investor.
The bulk of online investors employ ``market' orders rather than ``limit' orders, a risky practice when prices are volatile.
Though many people make rapid-fire trades in hopes of profiting from fluctuations in a stock's price, they often rely on the barest of price information.
And mechanics aside, even the best-equipped day traders still are competing against institutional investors with more experience, money and inside knowledge.
``When you're at Sears Point in driving school, you learn all the moves the professionals use,' said James F. Karel, president of Karel Capital Inc., a Burlingame investment management firm. ``But the fact of the matter is you are not a professional. If you were to come out of school and go onto the racetrack with professionals, you would be blown away. And that, in fact, is what's happening in a number of cases with day traders.'
The problem is that technology and the Internet have reshaped consumer expectations of what is -- or should be -- possible. Too many customers fail to understand the hierarchy of how trades are lined up and prioritized -- and how much can happen in a volatile market after they hit ``Send.' (See graphic, Page XXX.)
Market orders can be filled at unexpected prices. Limit orders can go unfilled. Trade confirmations to investors are delayed. Cancellation orders get to the exchange floor or market-maker after trades are completed. And the problems are likely to be magnified on topsy-turvy days when investors can least afford delays.
``Well, duh, the market is going crazy on you, and you want to treat it like a sunny afternoon. People need to have some understanding of fast-moving markets. . . .,' said Discover President Tom O'Connell. ``They appreciate the transparency of doing trading online, then get carried away with that and feel they have a constitutional right to get (the trade) executed the way they think it should be.'
As a day-trading hobbyist who trades as much as $20 million worth of stocks every quarter, Victor Batinovich has endured all those problems and heard all the explanations. Exasperated, he dumped his first online brokerage because he felt helpless once he e-mailed his orders.
``You lose control. You cannot cancel it, you cannot control the price or the filling of the order. It's strictly up to them,' said the San Jose man, who eventually moved his account to an online brokerage that promises swift executions. ``I don't feel comfortable when I don't have control. When I don't have control, I'd feel better being in Vegas. At least I could have some fun.'
As the Internet has evolved into a part of everyday life, the risk of system crashes has been well documented. That affects only the front end of an online trade, however. It's the back end -- when the order is finally in the brokerage's system and is executed -- that can matter more.
``The executions are horrendously slow' by the standards of Wall Street professionals, said Christopher A. Farrell, author of ``Day Trade Online.' ``It prevented me from trading the most volatile stocks profitably.'
Of course, speed of execution isn't the best measure. For day traders -- as well as investors in general -- it's more important to lock in a favorable price. Again, though, that's difficult to control through a typical online brokerage.
One reason is that many online brokerages do not actually execute trades. They are intermediaries who hand off trades to the dealers. On the New York Stock Exchange, the dealers are called specialists, and there is typically one per stock. On Nasdaq, they are called market-makers, and there is an average of 11 per stock.
These dealers are not disinterested order-takers. They play an essential role in the stock market because they are responsible for ensuring there's always a place where an investor can buy or sell a specific stock. But they often trade for their own accounts -- pitting themselves against individual investors.
A dealer's job can be a financially punishing at times. For one thing, a dealer tries to anticipate and profit from market moves, just like day traders. But the dealer also is responsible for maintaining an ``orderly' market for the stock. If there's a sell-off and there are no buyers for a given stock, a dealer must step up.
Similarly, if there's a buying spree and there are no sellers, the dealer must peddle some shares from his own inventory. If he's caught short, he sells shares he doesn't own -- but is committed to buying eventually. This process, known as ``shorting' shares, exposes him to losses if the price rises in the interim.
As risky as that is, though, these dealers have a unique knowledge of the supply and demand for a stock that they can use to trade profitably. NYSE specialists maintain the ``book' of orders and can gauge the buying or selling pressure that is building. Nasdaq market-makers don't maintain the same kind of book, but they're privy to similar market intelligence. They also profit by playing the ``spread' -- the difference between the best ``bid-and-ask' price from all the market-makers in that stock. (See graphic, Page XXX.)
For example, say the highest price any anyone is willing to pay for a stock -- the best ``bid' -- is 10; and the lowest price anyone is willing to sell it for -- the best ``ask' -- is 10 1/8. If you placed a market order to sell 1,000 shares, a dealer could buy your 1,000 shares at $10, then turn around and sell them to another investor for the ask price of 10 1/8 -- and pocket the 12 1/2-cent spread. That's $125 for every 1,000 shares. Over time, that seemingly insignificant spread can mount -- as revenues for dealers, as expenses for investors.
Market-makers commonly pay brokers a penny or two or more per share to steer trades their way, a process known as payment for order flow or preferencing. Dealers typically guarantee to execute trades at the best bid-ask price, but the practice is controversial. That's because competing market-makers have little incentive to improve the bid-ask price if another dealer is going to get the orders anyway because of an agreement with brokers.
Meanwhile, the investor picks up the tab. The brokerage charges the investor a commission and earns a few pennies for preferencing, and the dealer plays the spread. If a brokerage has its own market-making unit, it can keep the commission and play the spread, too. And if a dealer thinks you've misjudged the market, it can buy your shares or sell some from its own inventory.
``The real reason these commissions are so cheap is they can't wait for you to place that trade so they can take the other side of it,' said author Farrell. ``It's no different than going to a casino and getting free comps. It's a way to lure you in and get you to bet against the house.'
Spreads are a cost of buying and selling stocks that can easily outweigh the savings from cheap commissions. The spread doesn't come out of an investor's pocket directly, but it can spell the difference between profit or loss -- especially for day traders who grind out gains on tiny price fluctuations.
For example, a day trader buying a stock for 10 1/8 would lose money by selling immediately, because the dealer would pay only 10. Unless the trader goes around the dealer to find a buyer, the trader can't recover that spread plus commissions unless the dealer bumps up his bid more than an one-eighth of a point. In short, wide spreads make profits more elusive.
One basic trading strategy is to buy and sell inside the spread. Brokerages already are obliged to seek a price between the posted bid and ask prices -- a practice known as ``price improvement.' But critics charge that there's little incentive for dealers to do so. Business Week reported in April that the odds of seeing that occur are ``less than 50-50 on the NYSE -- and worse on Nasdaq.'
Of course, the real key to successful trading is to be right. And the best chance you have of being right is to have all the essential information at your fingertips.
Yet many day traders and other investors base their Nasdaq-stock decisions on limited Level I data, a stock quote from their brokerage that shows only the market's best bid and ask prices. Most brokerages provide real-time quotes, either in single snapshots or a stream that tracks each tick. But some provide quotes that are delayed at least 15 minutes.
Savvy day traders step up to Level II data. It shows not only the market's best bid and offer, but it also reports the bids and offers for every market-maker and the number of shares available for each bid and offer.
For example, a trader might spot an order to buy 10,000 shares of a stock from one market-maker when all of the market-makers are offering a total of only 1,000 for sale. He might reason that the buying pressure will push prices higher. By moving quickly, the trader can ride the wave a bit.
Or can he?
It can be a costly mistake to assume that computers, Internet access, sophisticated software and Level II information are a match for inside knowledge and deep pockets.
In reality, the day trader who anticipates a wave of buying might be playing into the hands of a large institutional player, like a mutual fund, that actually wants to sell a much larger block. If the fund played it straight and posted a huge sell order, it would risk spooking the market and sending prices tumbling as it dumped its stake. By posting a big buy order, however, the mutual fund might goad speculators into rushing in and bidding up the price as it unloads its shares.
``It's mass psychology here. The next thing you know, the one that started the stampede got what he wanted,' said Burlingame investment manager Karel. ``Day traders are not in the minds of the players themselves. That's why they don't necessarily know which card will be played next. Their charts suggest something, but the (day traders) aren't the players themselves. What has misled tens of thousands of day traders is the mechanism they use. The Internet has given them the illusion they are the player.'
Contact Mark Schwanhausser at mschwanhausser@sjmercury.com or (408) 920-5543.
¸1999 Mercury Center.
sjmercury.com
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