By Chris Lane
By Jeff Balke
By Aaron Reiss
By Angelica Leicht
By Dianna Wray
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By Camilo Smith
By Craig Malisow
But when a stock is bought through NASDAQ, it's bought in cyberspace from what are known as market makers -- large brokerage houses that register with NASDAQ to trade in a particular stock. Market makers must quote offers both to buy and to sell a particular stock. Whether two or 20 market makers trade in a stock, all of their prices are instantaneously displayed throughout the country, linked by NASDAQ's mainframe computers in Rockville, Maryland. Typically, the market makers offer to sell a stock for more than they are willing to pay, with the difference often being a quarter of a point to an eighth of point; this difference is known as the spread.
And since the market makers can all see their competitors' prices, they're usually in synch. But when a market maker places a large order to either buy or sell, the market can start moving, and woe to those who don't quickly adjust their prices with the rest of the pack. In five, ten, 15 seconds they can be SOESed, hit by trades made through NASDAQ's computerized Small Order Execution System, which automatically places orders for a thousand shares or less at prices that the laggards had been a few seconds slow to change. Then once those seconds are up and the prices have been adjusted, the SOES bandits can sell the stock right back to the people they just bought it from, and make a profit in the process. It is like watching the slowest animal in the herd falling to a quick predator.
SOES traders are looking for small profits from these transactions, a quarter of a point here, an eighth of a point there, even a "teeny," a 16th of a point. But at the end of a day, those small points can add up to a few thousand dollars. The market makers complain that the SOES bandits are taking advantage of the Small Order Execution System, using it for something it was not designed to do. But the SOES bandits think that's just the big guys complaining they no longer have the field all to themselves, and they just keep trading. Several days last summer, SOES traders made so many deals that they overwhelmed NASDAQ's computers, and the SOES had to be temporarily shut down.
In 1991, Chris Block was working in the Houston office of Lehman Brothers as a retail broker, feeling the lash of his sales manager. Block's job was to call strangers and sell them on stock deals, and one day the stranger he called was Harvey Houtkin. Though Block managed to interest Houtkin in some offerings his company was touting, Houtkin did his own selling job right back. Retail brokerages, he told the young broker, were relics of the past, and a waste of time for someone with initiative. "You're nothing but a fucking mushroom," Houtkin told Block. "They keep you in the dark and feed you shit." What Block needed to do, Houtkin said, was learn about something called SOES. And Houtkin was the man to introduce him to it.
At the time, the SOES system was only five years old. It had been instituted following the stock market crash of October 1987. Because orders were still largely being taken over the phone then, many brokerages had been overwhelmed with calls during the market collapse. So they quit answering, letting the small investors twist in the wind while taking care of their larger corporate clients. The orders of some small investors were not filled for as long as a week -- and by that time, their stocks had plummeted in value. After a federal investigation, NASDAQ installed the SOES program to help small investors place orders instantaneously. The idea was to create a level playing field for small investors.
But Houtkin realized the SOES program could also be used to skim behind the major dealers, catching them asleep and making money in the process. The majors fought back by complaining to NASDAQ, which tried to restrict SOES trades. For a time the number of trades made in any one account were limited; Houtkin and his traders reacted by opening lots of accounts in different names.
Soon, Houtkin came to see SOES as the democratizing of the stock market. He was particularly vocal about how market makers influenced the "spread," the difference between what they sell a stock for and how much they'll pay to buy it. In addition to commissions for buying and selling stocks for their customers, some market makers will pay brokers a few cents a share for every trade they send their way. This is called "payment for order flow," and helps the market makers influence the spread by giving them control of when they place buy orders and sell orders. Houtkin saw "payment for order flow" to brokers as nothing more than a kickback.
Houtkin and his early SOES bandits hurt the big traders in two ways. Not only did they pry money out of them by forcing them to instantaneously honor their bids in the spread, but they were doing something far more potentially harmful: they were closing the spread. The market makers could still jiggle and head fake the market by timing their large orders, but the profits were thinner when SOES traders were swooping down like a cloud of gnats on every moving market, forcing the market makers to quickly adjust their prices. Houtkin took up the name SOES bandit and spoke loudly and often that he was one, not only through the news media, but in a self-published, how-to book titled The SOES Bandit's Guide, Day Trading in the 21st Century. The book has a burglar's mask on the cover.