Electronic Trading: Conclusion

If you are a long-term investor, you can take this tutorial with a grain of salt. At least now you have some insight into how electronic systems give direct access to the market. We hope this has enlightened your outlook and helped you achieve a greater understanding of how the execution of stock orders is done. For those who are looking to become a trader, this is the tip of the iceberg and we'd advise you to do a lot more research in this area before jumping in.

Let's recap what we have learned:

•The NYSE is an auction market and uses specialists to trade securities.
•The Nasdaq is an OTC market where trading is facilitated through market makers.
•Each stock listed on the NYSE is allocated to a specialist who matches up buyers and sellers, provides liquidity and finds the fair price at the beginning of each trading day.
•A market maker provides continuous bid and offer prices within a prescribed percentage spread for shares in which they are designated to make a market.
•SuperDOT system is an electronic system used to place orders for stocks on the NYSE.
•ECNs network major brokerages and traders, so that they can trade between themselves without involving a middleman.
•SOES is an automatic order execution for individual traders with orders less than or equal to 1,000 shares.
•There are three levels on the Nasdaq that vary on the amount of information and access they provide to investors.

Electronic Trading: Small Order Execution System (SOES)

The lack of liquidity after the 1987 market crash lead the Nasdaq to implement a mandatory system to provide automatic order execution for individual traders with orders less than or equal to 1,000 shares. (For stocks with low volume, it may be less than 200 shares). Market makers must accept small order execution system (SOES) orders and so this provides excellent liquidity for smaller investors and traders.

There are several restrictions for those who are using SOES, rather than a traditional ECN, to place their orders.

1) Trades may not be in excess of 1,000 shares for a particular stock.

2) SOES doesn't not allow trades in stocks that are trading at prices greater than $250 per share.

3) Once a trader places an order through SOES, he or she must wait at least five minutes to place a trade through SOES on the same stock.

4) Short selling through SOES must comply with SEC rules and be on a zero plus tick basis only.

5) Institutions and brokers are not allowed to place orders for their own accounts through SOES, but they can for a client's account.

6) Market makers must honor their advertised bid/ask prices to SOES orders, provided that they are for the amount that the market maker is looking for.

Initially, when SOES was mandatory, it was met with heavy pessimism from Nasdaq member firms because it forced them to execute all SOES trades that met the market maker's advertised price. There were significant limitations implemented to prevent day traders from exploiting the system and taking advantage of old prices quoted by market makers.

SOES has revamped the trading market for individual investors. It has given small investors and traders the opportunity to compete on a level playing field for access to orders and execution.

Electronic Trading: SuperDOT

Initially introduced as DOT, the SuperDOT system (Super Designated Order Turnaround System) is an electronic system used to place orders for stocks that are listed, which usually refers to those trading on the New York Stock Exchange (NYSE). Keep in mind that SuperDOT is not to be confused with an electronic communication network (ECN), which we will discuss next.

The SuperDOT order-routing system facilitates the transmission of both market and limit orders directly to the trading post (and specialist) where the particular security is traded. This allows for a more efficient transaction because the order can be delivered directly to the specialist rather than phoned down to a floor trader and done manually. SuperDOT can be used for trades under 100,000 shares with priority given to orders of 2,100 shares or less. More than three-quarters of the orders executed through the NYSE are done through the assistance of the SuperDOT system.

After the order has been executed, the report of the transaction is sent back to the broker through the SuperDOT system. This means faster execution of the order and faster reporting of the trade. While most individual investors cannot have access to SuperDOT directly, there are complimentary systems offered by many brokers that replicate similar order executions provided by SuperDOT.

Originally, the SuperDOT system was designed for small order entry, but increasingly, SuperDOT has played a big role in portfolio or basket trading.

Electronic Trading: The Role of a Market Maker

Market makers compete for customer order flows by displaying buy and sell quotations for a guaranteed number of shares. The difference between the price at which a market maker is willing to buy a security and the price at which the firm is willing to sell it is called the market maker spread. Because each market maker can either buy or sell a stock at any given time, the spread represents the market maker's profit on each trade. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. There can be anywhere from four to 40 (or more) market makers for a particular stock depending on the average daily volume. The market makers play an important role in the secondary market as catalysts, particularly for enhancing stock liquidity and, therefore, for promoting long-term growth in the market.

Market makers must maintain continuous two-sided quotes (bid and ask) within a predefined spread. A market is created when the designated market maker quotes bids and offers over a period of time. They ensure there is a buyer for every sell order and a seller for every buy order at any time.

Once the market maker has entered a price, he or she is obligated to either buy or sell at least 1,000 securities at that advertised price. Once the market maker has either bought or sold these shares, he or she may then "leave the market" and enter a new bid or ask price to make a profit on the previous trade.

For example, let's say that a market maker has entered a sell order for Microsoft (MSFT) and the bid/ask is $65.25/$65.30. The market maker can try to sell shares of MSFT at $65.30. If this is what the market maker chooses to do, he or she can then turn around and enter a bid order to buy shares in MSFT. The market maker can bid higher or lower than the current bid of $65.25. If he or she enters a bid at $65.26 then a new market is created (referred to as making a market) because that bid price is now the best bid. If the market maker attracts a seller at the new bid price of $65.26 then he or she has successfully "made the spread." The market maker sold 1,000 shares at $65.30 and bought these shares back at $65.26. As a result, the market maker made $40 (1,000 shares x $0.04) on the difference between the two transactions. This might not seem like much, but doing this repeatedly with larger order sizes can provide lucrative profits. All day long market makers do this, providing liquidity to individual and institutional investors. The major risk for the market maker is the time lapse between the two transactions; the faster he or she can make the spread the more money the market maker has the potential to make.

However, making money from the differences in bid and ask prices is not the only function of market makers. Their first priority is to provide liquidity to their own firm's clients, for which they will receive a commission. They may also facilitate trading for other brokerage firms, which is very similar to the duties of a specialist.

It should also be noted that market makers are required by law to give customers the best bid or ask price for each market order transaction. This ensures a fair and reasonable two-sided market. If these regulations were not in place, customers' profits would be gouged and share prices would be much more volatile than they already are.

Electronic Trading: The Role of a Specialist

The NYSE facilitates trading through a human being who is known as the specialist. Each stock listed on the NYSE is allocated to a specialist and all the buying and selling of a stock occurs at the location of this person, known as "the trading post." Buyers and sellers represented by a floor trader will meet at the trading post to learn about the best current bid and ask price for a security. These bid and ask offers are called out loud and indicate the current prices to any interested party. A trade will be executed when the bid and ask orders meet. (For more insight, see Why The Bid-Ask Spread Is So Important.)

The specialist doesn't only match up buyers and sellers. Many specialists are forced to hold an inventory of shares themselves to minimize the imbalance of buy and sell orders. The specialist does this until an equilibrium price is reached, which is when demand and supply are very close. Buying an inventory of stocks is not a common occurrence. In fact, it is estimated that a specialist will be in on only one out of every 10-15 trades.

Another duty that a specialist attends to occurs if a customer's order is priced at a level higher than the lowest ask, or lower than the best bid price (known as a stop order). The specialist will then hold the order and execute it if and when the price of the stock reaches the level specified by the customer. (For related reading, check out Understanding Order Execution and The Basics Of Order Entry.)

A final responsibility of the specialist is to find a fair price for each of the stocks that he or she is responsible for at the beginning of every trading day. This fair price is based on the current supply and demand of the stock. The NYSE opens for trading at 9:30am, but if the specialist can't find a fair price, he or she may delay the opening of trading on a stock until that fair price is found.

It is the specialist's job to act in a way that benefits the public. Because specialists are responsible for keeping the market in equilibrium, they are required to execute all customer orders ahead of their own.

Electronic Trading: Introduction

When it comes to electronic trading, for most individual investors, taking a long-term buy-and-hold approach is probably the best strategy. Most of us simply don't have the time or the expertise to trade for a living. But for some investors, trading can be an extremely lucrative profession.

There have always been professionals who made their living off of trading. It wasn't until recently, however, that technology enabled individuals who weren't working for a brokerage to directly access the markets. This tutorial will delve into the workings of the electronic systems that allow this direct access. We'll also talk about the differences between the New York Stock Exchange (NYSE) and the Nasdaq and learn how market trades are executed, both by market makers and by specialists.

Whether you are an aspiring trader or a seasoned investor looking to find out how it all works, this tutorial explains all the nitty-gritty electronic trading systems in layman's terms. Is electronic trading a new way for you to build you own portfolio?

Stock-Picking Strategies: Conclusion

Let's run through a quick recap of the foundational concepts that we covered in our look at the most well-known stock-picking strategies and techniques:

•Most of the strategies discussed in this tutorial use the tools and techniques of fundamental analysis, whose main objective is to find the worth of a company, or its intrinsic value.
•In quantitative analysis, a company is worth the sum of its discounted cash flows. In other words, it is worth all of its future profits added together.
•Some qualitative factors affecting the value of a company are its management, business model, industry and brand name.
•Value investors, concerned with the present, look for stocks selling at a price that is lower than the estimated worth of the company, as reflected by its fundamentals. Growth investors are concerned with the future, buying companies that may be trading higher than their intrinsic worth but show the potential to grow and one day exceed their current valuations.
•The GARP strategy is a combination of both growth and value: investors concerned with 'growth at a reasonable price' look for companies that are somewhat undervalued given their growth potential.
•Income investors, seeking a steady stream of income from their stocks, look for solid companies that pay a high but sustainable dividend yield.
•CAN SLIM analyzes these factors of companies: current earnings, annual earnings, new changes, supply and demand, leadership in industry, institutional sponsorship, and market direction.
•Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial Average (DJIA) with the highest dividend yield.
•Technical analysis, the polar opposite of fundamental analysis, is not concerned with a stock's intrinsic value, but instead looks at past market activity to determine future price movements.

Stock-Picking Strategies: Dogs of the Dow

The investing strategy which focuses on Dogs of the Dow was popularized by Michael Higgins in his book, "Beating the Dow". The strategy's simplicity is one of its most attractive attributes. The Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial Average (DJIA) with the highest dividend yield. In the Dogs of the Dow strategy, the investor shuffles around his or her portfolio, adjusting it so that it is always equally allocated in each of these 10 stocks.

Typically, such an investor would need to completely rid his or her portfolio of about three to four stocks every year and replace them with different ones. The stocks are usually replaced because their dividend yields have fallen out of the top 10, or occasionally, because they have been removed from the DJIA altogether.

Is it Really that Simple?
Yes, this strategy really is as simple as it sounds. At the end of every year, you reassess the 30 components of the DJIA, determine which ones have the highest dividend yield, and ask your broker to make your portfolio as equally weighted in each of these 10 stocks as possible. Hold onto these 10 stocks for one calendar year, until the following Jan 1, and repeat the process. This is a long-term strategy, requiring a long period to see results. There have been a few years in which the Dow has outperformed the Dogs, so it is the long-term averages that proponents of the strategy rely on.

The Premise
The premise of this investment style is that the Dow laggards, which are temporarily out-of-favor stocks, are still good companies because they are still included in the DJIA; therefore, holding on to them is a smart idea, in theory. Once these companies rebound and the market has revalued them properly (or so you hope), you can sell them and replenish your portfolio with other good companies that are temporarily out of favor. Companies in the Dow have historically been very stable companies that can weather any market decline with their solid balance sheets and strong fundamentals. Furthermore, because there is a committee perpetually tinkering with the DJIA's components, you can rest assured that the DJIA is made up of good, solid companies.

By the Numbers
As mentioned earlier, one of the big attractions of the Dogs of the Dow strategy is its simplicity; the other is its performance. From 1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dows averaged 11%. The performance between 1973 and 1996 was even more impressive, as the Dogs returned 20.3% annually, whereas the Dows averaged 15.8%.

Variations of the Dogs
Because of this strategy's simplicity and its returns, many have tried to alter it in an attempt to refine it, making it both simpler and higher yielding. There is the Dow 5, which includes the five Dogs of the Dow that have the lowest per share price. Then there is the Dow 4, which includes the 4 highest priced stocks of the Dow 5. Finally, there is the Foolish 4, made famous by the Motley Fool, which chooses the same stocks as the Dow 4, but allocates 40% of the portfolio to the lowest priced of these four stocks and 20% to the other three stocks.

These variations of the Dogs of the Dow were all developed using backtesting, or testing strategies on old data. The likelihood of these strategies outperforming the Dogs of the Dow or the DJIA in the future is very uncertain; however, the results of the backtesting are interesting. The table below is based on data from 1973-1996.



Before you go out and start applying one of these strategies, consider this: picking the highest yielding stocks makes some intuitive sense, but picking stocks based strictly on price seems odd. Share price is a fairly relative thing; a company could split its shares but still be worth the same, simply having twice as many shares with half the share price. When it comes to the variations on the Dogs of the Dow, there are many more questions than there are answers.




Dogs Not Fool Proof
As is the case with the other strategies we've looked at, the Dogs of the Dow strategy is not fool-proof. The theory puts a lot of faith in the assumption that the time period from the mid-20th century to the turn of the 21st century will repeat itself over the long run. If this assumption is accurate, the Dogs will provide about a 3% greater return than the Dow, but this is by no means guaranteed.

Conclusion
The Dogs of the Dow is a simple and effective strategy based on the results of the last 50 years. Pick the 10 highest yielding stocks of the 30 Dow stocks, and weigh your portfolio equally among them, adjusting the portfolio annually, and you can expect about a 3% outperformance of the Dow. That is, if history repeats itself.