By Chris Lane
By Jeff Balke
By Aaron Reiss
By Angelica Leicht
By Dianna Wray
By Aaron Reiss
By Camilo Smith
By Craig Malisow
Most of the bandits are guys, but not all of them. One of the best is a woman, Stephanie Clark, and she comes gliding into the offices of Block Trading just a few moments before the bell sounds to mark the opening of the NASDAQ market. Clark hopes to make a noon workout with her personal trainer at a Galleria health club, so she's wearing pink shorts pulled over white spandex shorts and a white stenciled T-shirt that says Beverly Hills, which is where she might be from, a young, freckled Lauren Bacall, with a wide, pretty mouth and well-cut blond hair on top of which rides a pair of sleek designer sunglasses.
She settles into her high-backed office chair like a fighter pilot settling into a cockpit and looks around. A television wired to CNN flickers silently on a back wall, but she doesn't pay much attention to that. By the time financial news makes it to CNN, the people in the know have already heard and reacted to it. More important is the orange monitor that sits between her and another trader; it's here that major stock orders are registered. But most important is the color monitor that stares straight back at her. It's on this tube that the workings of the all-electronic NASDAQ market flit by -- who wants to sell, who wants to buy, what prices are being floated, what offers are being accepted. It's a code, all of it, and to the person who can break that code, a very simple prize is offered: profits.
Clark knows about profits. The day before, she made money from home, calling in her orders through a speaker phone while watching a computer. She made money calling in from her car on the drive home. She made money standing on her patio in her bathing suit, watering her new 12-foot-high bougainvillea. Around the edge of her computer monitor, her obsession is made clear. There, printed like a mantra, is the phrase "Chu-Ching" bracketed by dollar signs. Chu-ching, the sound a cash register makes. Chu-ching, the sound that Clark wants to hear every time she makes a trade. Chu-ching, the sound that likely reverberates, in one form or another, through the dreams of the 50 odd other SOES bandits settling into their own high-backed chairs around Clark. Chu-ching, the tune that could well serve as the anthem of SOES bandits nationwide. Chu-ching, chu-ching, chu-ching. The sound of the big boys of the stock market being SOESed.
SOES stands for Small Order Execution System and, like most phrases connected to the stock market, means nothing to the average person on the street. To most of us, the stock market is a series of numbers that fill unread columns in the back of the daily paper's financial section. Or it may be an investment tool, a hedge against inflation, a way to bolster retirement income by riding the coattails of the capitalist system.
But to the people who are actually in the stock market it's something completely different. It is, as financial writer Adam Smith noted back in the late '60s when the gray men of Wall Street were beginning to acquire a public face, a game, one played daily and with other people's money. It is also a game whose players have historically been tightly restricted. The wealthy were welcomed in; everyone else was invited to stay outside and do their stock buying through the intermediary of those with clout.
That's why the "S" for small in SOES is so galling to big brokerage houses such as Merrill Lynch, Goldman Sachs and Oppenheimer. The "S" means they are being bypassed, and they are not happy about it. It is as though the biggest, oldest and slowest bullies in the playground have had their private game invaded by a group of fast, high-spirited kids.
Traditionally, if a client placed an order for stock, a broker would phone several other brokerages that were dealing in the stock, find the best price and make a deal. It was, by SOES standards, a relatively leisurely process. In 1971, the National Association of Security Dealers, a private, self-regulating agency composed of the nation's nearly half-million stockbrokers and 5,300 brokerage firms, created a computerized stock market, NASDAQ. NASDAQ has grown into the second largest stock exchange in the country after the New York Stock Exchange, doing more than a trillion dollars of business a year in the stocks of more than 5,000 companies. When you buy a stock from the New York Stock Exchange, you are essentially buying from other investors in a daylong auction market conducted by traders competing on the raucous Wall Street trading floor. Regardless of technology, the NYSE is still something of a 19th-century process.
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.
It was when Houtkin was starting to preach the gospel of SOES that Block dialed him up. He listened to what the man had to say, even if at first he didn't take him too seriously. He and his University of Texas classmate, Jeff Burke, were making good money at Lehman Brothers and they were only three years out of college. Of course, they weren't exactly playing the market, either. All they were doing was pitching the company's products, often to strangers, and taking a lot of rejection. Every morning, Block and Burke would check out stock prices on the computer screen and see what they were missing.
So when Chris Block flew to see his parents on Staten Island on Thanksgiving of 1991, he decided to check out Houtkin's basement SOES operation in suburban New York. Block was impressed, but the market was good when he got back to Houston and there were sales to be made. Then the market went down and so did his commissions.
"Harvey had given us the mushroom talk once again, and that opened our eyes," recalls Burke. "We were just glorified telephone salesmen."
Maybe, Block and Burke decided, it was time to make a move. In March 1992, they quit their jobs and drove cross-country to Staten Island, where they lived in Block's parents' beach house and commuted one hour a day to learn the secrets of SOES banditry from Harvey Houtkin.
Burke caught on to the trading faster than Block, while Block had more of an aptitude for business. It didn't taken the pair long to figure out that they wanted to do more than just trade. They wanted to set up their own SOES brokerage. Block returned to Houston and did something he already knew he was good at: cold calling. Going alphabetically through the yellow pages, he called brokerage after brokerage and got nothing but rejection until he hit the "t"s. Texas Capital on the third floor of the Galleria would lease him a room in the corner of its retail space. Block set up two computers on a card table, plugged into NASDAQ and called Jeff Burke back to Texas. In November 1992, Block Trading got off the ground with their first SOES trade.
All the traders agree that the only way to become a SOES trader is to watch one in action. Burke was part of Block Trading not only to make money off SOES, but to show others how it was done. The pair added computers and new traders, some of them their friends from college and high school. "We have traders from sales, former accountants, brokers, from all walks of life," Block says. "We have people making $20,000 to $40,000 all the way up to $300,000. The market makers never anticipated what would happen. Now they are cursing us."
There is a picture of Block and Burke at a Halloween costume party a couple of years ago when they dressed up as the Blues Brothers. In fedora hats, blue suits and dark glasses, Block is a perfect John Belushi, and Burke fits as the earnest, self-contained Dan Aykroyd. It's a telling photograph, because Block and Burke's operation has a similarly improvised quality, as though the two were making it up as they went along, just putting on costumes and going to a party with a bunch of friends. Now, four years into Block Trading, with nine offices and a small army of SOES traders working them, Block and Burke are dressing up as tycoons. They wear double-breasted suits to work and prop their feet up on the conference table of their corporate offices, cluttered as a sophomore dorm room, on the tenth floor of the Galleria financial tower. Just across the hall are the immaculate, gleaming wooden doors of Merrill Lynch, and the juxtaposition makes it clear that this is not just a battle about profits, of insiders against outsiders, big guys against little guys. It's a battle of cultural styles. And so when Block and Burke take out $30 Havana cigars to pose for a picture on the trading floor, you can tell that they're serious enough not to take themselves too seriously. And that, as far as the big guys are concerned, makes them dangerous.
Another reason they're dangerous is that Block and Burke, like Houtkin, have become evangelists of the SOES faith. Stephanie Clark is one who heard the message and believed. A year ago, Clark was working as a sales assistant at Oppenheimer, posting the sales of $3 million-a-year brokers and earning a nice salary, with bonuses if her brokers had big years. Not bad for a single, 27-year-old with two years of junior college.
But Clark couldn't help watching the fluctuating stock prices on Oppenheimer's computers. She knew more than the average sales assistant about the money to be made from those flickering screens. In 1992, she had been the first employee of Block Trading. She worked as an inputter, taking orders from traders and sending them on their electronic way. Inputting SOES trades required a cool head and a quick hand, and Clark had both. Still, she decided to try working with a big brokerage. But after a few months at Oppenheimer, she was itching to leave the retail brokerage and try SOES trading. Last summer, after finding three investors who staked her to $100,000 in trading capital, she bailed on Oppenheimer and knocked again on the door of Block Trading.
Clark has turned out to be particularly good SOES bandit. She has a special talent for short selling, in which she promises to sell a stock at one price, anticipating that she can buy the stock moments later at a falling price. Last fall, the market kept dropping, and by the end of the year, she had made so many trades that she had to hire an accountant to keep track of her money. (Intrigued, the accountant would close his business and become a SOES trader, too.) In December alone, when the market dropped precipitously, she made $75,000 for her account.
Clark sometimes says she is afraid, but she doesn't act like it. SOES trading goes best if you keep cool, and Clark is cool. At her right on Tuesday, May 8, sat Rhett Baker, a friend of Jeff Burke's since they both attended Memorial High School. Baker stays calm by dipping mentholated Skoal, spitting into a James and the Giant Peach soft-drink cup. A couple of chairs to Clark's left sat Phil Naftolin, a short, jolly guy wearing wire-rimmed glasses on a round face sharpened by a goatee. He is a UT law graduate who decided lawyering wasn't for him. He went to high school with Jeff Burke, too. Naftolin takes cigarette breaks in the garage when the pressure is high.
At lunch the day before, Baker, who claims to have enjoyed working in the retail end of Smith Barney, had said, "The thing that drove me away was how I was beating customers. I had to bring in the money; I would make the cold calls. Then I would go to the trading desk and buy a stock, and Smith Barney would make money on the spread. I felt the desk should make money on its volume, not on my client."
Clark trades according to her feel of the market. She gets insight from half a dozen sources on the screens before her, including order flow, knowing the strengths of different market makers, watching the indexes. All this is melded into an intuition heightened by trading the same group of stocks day after day. The first 30 minutes of the trading day are intense, as market makers sort out their positions from the day before, adjust their prices and see what sort of response they get. As the colored columns of figures that show the bid and ask prices rise and fall, the SOES traders prepare their trades by telling their inputters to "load" a certain stock at a certain rate. It might take a retail broker 20 minutes to make a trade by phoning in an order; the broker across the table from a SOES trader makes an order in two seconds.
And often within a few seconds a trader will know if he's made a profit. The worst mistake in SOES trading is to hold onto a position. Better to lose an eighth of a point and get out than let it go to a quarter or a half.
Decent traders react to a rise or fall in prices. The best anticipate the market and act accordingly. On May 8, the Dow swung 78 points and Clark was selling short all the way. She never made it to her workout with her personal trainer, and by the end of the day she was working into a feverish rally. She looked at the spread on U.S. Robotics and said she wouldn't go near it.
"I'm too scared," she noted. "See? Goldman Sachs is offering. They're a power. It's up eight and a half. It has had a huge range. Watch those thousand-share bids. When it hits the bid, it's going to go down. Look. Goldman has switched from the bid side to the sell side."
Suddenly she turned to her inputter and, almost as though the words surprised her, she was saying, "Load to sell Robotics at 141." Then she was looking at another column of figures, and suddenly she sang out, "Sell Robotics."
"We're not day traders," she said, "we're more like minute traders."
By the time the closing bell rang at 3 p.m., she had made 64 trades and was up nine and seventh eighths for the day. She had netted $6,425.
Rhett Baker was also up a few thousand dollars, but Phil Naftolin had left by midmorning. He had been trading long, and "long was wrong" he would say later. By 8:30 a.m. he had been muttering, as though to turn back the tide, "Steph, I'm getting slaughtered."
The market had been moving hard and fast, opportunity sweeping by on the screen, but Naftolin had made all the wrong moves. He was as far down as Clark was up. It happens. Not even bandits are guaranteed a profit.
Well, not all bandits are guaranteed a profit. But if you happen to own the hideout, you can do pretty well. The same day that Stephanie Clark made her $6,425, she paid Block Trading $3,456 in commissions. Compared to large brokerage house commissions, Block's commissions are minimal: $54 for each trade. Since a full-time trader makes anywhere from 20 to 70 trades daily, and a franchise might manage the trades of a couple of dozen traders, it's easy to see where the money is to be made. Burke and Block have nine offices, including four in Houston, one in Tyler and another in San Antonio. They have others coming up in Dallas, Sugar Land, Wichita, Kansas and even New York. This year, the commissions to Block Trading from their various offices should run around $18 million. Even after you take out for overhead, that's not bad.
That may be one reason why Phil Naftolin could take his day of loss with equanimity: he's planning to get into the hideout side of the business himself. On May 16, Block Trading held a going-away party for Naftolin and Rhett Baker; they were getting ready to leave for Phoenix, where they would open a new Block Trading franchise. Naftolin, who says he knew nothing about the stock market, learned about SOES trading by watching Jeff Burke trade for a couple of weeks and writing down questions to ask him at the end of the day. Now he'll be passing on the secrets of SOES to customers in Phoenix. And one of the first things he will tell them is that SOES trading is not guaranteed to work every day. It works better in a volatile market than a flat market. And not everyone is sharp every day.
The going away party was held at World Bait, an unpretentious little bar behind the chichi 8.0. With the company picking up the tab, you know that by late in the evening someone is going to be drinking double shots and making a fool of himself, but it's early now, and two sparkling women are talking to Naftolin, who is perched on a bar stool, long recovered from his $6,000 loss, not just a trader anymore, but a franchise owner, a man who is going to spread the gospel in Arizona. Baker, meanwhile, is circulating around the room like a handsome older fraternity boy in his polo shirt and khaki trousers and sockless loafers.
This is a heady time for SOES bandits. Where once they were all but unknown outside a small group of stock traders, they're starting to get a public profile. Ads promising to teach the secrets of SOES pop up in newspapers; proud SOES bandits can be seen in restaurants wearing T-shirts emblazoned with the slogan, "SOES traders do it over the counter." The prophets of SOES see this as evidence that their message is being heard, that the once august stock market is being opened up to the little guy. Sure, the little guy may need around $100 grand to get into the game, but that's a lot better than the millions it once took.
But this is also a perilous time for SOES bandits. The higher visibility has resulted in the big guys trying again to rein them in. The National Association of Securities Dealers, whose board is made up of market makers, has proposed that market makers be given a 20 second delay in the computer system to adjust their prices, a delay that would cut into the SOES bandits speed advantage, and which they contend is patently unfair. Such a delay, say SOES traders, would once again put all the power in the hands of the market makers.
In this debate, the Securities and Exchange Commission, which regulates the stock markets, may end up weighing in on the side of the SOES traders. In 1994, two university professors published a study of market manipulation by the large brokerage firms that confirmed some of Harvey Houtkin's charges against them. And last year, the SEC began its own investigation of market manipulation in NASDAQ. Maybe, the SEC seemed to be saying, the bandits weren't so bad after all. Maybe they should be compared not to parasites but to helpful symbionts, cleaning up around a large animal and keeping it healthy.
Whatever happens, Burke and Block are enjoying playing the game. They love tweaking the power brokers; change doesn't perturb them. They thrive on it. Change jobs, change careers, change cities, change the stock market. If NASDAQ changes the rules, they'll just adapt.
At the World Bait going away party for his new franchisees, Jeff Burke drives up in a new red Ferrari convertible. Burke is taking a study break, for he's cramming for the test to get an advanced stockbroker's license. Study hard, party hard. Stephanie Clark is there, too. She parked her silver Porsche Carrera convertible right in front of the bar. When she first made big money last fall she bought a Lexus sedan. But that was too sedate, a retail stockbroker's kind of car. It wasn't nearly agile and quick enough for a SOES bandit.