Daily Speculations

September 2003

Spec Forum: Specialists

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Ken Smith, Old Geezer with Broken Cane: I hesitate to post anything on this site, since I am not a professional. And this post is not something that came from a spreadsheet; it is simply an explanation of how it works. 

When you are buying stock shares in a company who is selling you these shares?  Who?  Particularly when shares are traded near the top of a run-up, when prices are high.  You are getting shares from a specialist who borrowed shares and sold these shares to you. The Specialist, or the Market Maker, did not own these stocks then sell them to you; that is, he does not always own them, sometimes he does and he must make a profit on what he owns, to stay in business (if he figured there was more profit in the stock you would not get it). But any time you buy at a high you can be sure you are getting stock that was borrowed and whatever price was obtained was on borrowed shares and must be covered.

He borrowed them. What does that mean? It means he has to cover his shorts, that's what it means. The shares you bought during a marketing campaign of hot stocks, what do you suppose happens to their value?  Since the specialist is in  the marketing business, selling merchandise, and in this case selling borrowed merchandise, how can he stay in business unless he drives price down so he can cover his shorts?

You are not buying shares from another investor who holds shares. You are buying from a middleman. The middleman controls price, you don't control it, the other investor does not control it. The middleman controls whether price goes up and goes down. The entire world, except insiders, believe they are buying shares from a seller and the specialist is merely involved in the transaction to see that ownership is transferred and cuts a fee for doing so.

Not true. Once you see the specialist is selling you shares he has borrowed you can understand the specialist must bring price down to cover his action. You gamble. The Specialist, no.

This is not to say the specialist does not have inventory to sell, he does. And this inventory must make a profit for him (he may borrow from his own account in fact, to sell short to the public). How is he going to profit if other funds and the public control price, control HIM?  He runs price up after his base of shares has been purchased at the bottom when his control of the media has scared you into selling.

 You buy shares because the big game hunters, the specialists, have control over the financial media. The marketing of the fear factor thru media gives you incentive to sell your stocks. The specialist buys from you in the downdraft. Specialist finally stops the downdraft by covering his shorts.

Then another media campaign is begun and hope springs anew in you and the public and fund managers. Then the specialist increases price to sell you the shares he has bought on the way down.

 He's got you coming and going.  This is true of funds and is true of the public and is true of at-home traders.

 All this stuff about Excel, financial gibberish, accounting hokey, history of events, news, is delusion.

*Credit to Richard Ney for original exposition of this subject.

**Funds such as Fidelity are also Specialists, have own seats. If you have an account with them they always know where your vulnerability is.  And they profit by this.  In the case of Fidelity, I was told by one of their employees "Fidelity wants ALL the money."  They got 95 grand from me personally; from a half-million others also.  Lack did not get it, Fidelity did - as an insider to stock I held and as a specialist.

***Also miffed about all the crap I read about markets.

Victor Niederhoffer: Let me applaud Mr. Ken Smith's recent insightful post on specialists. I have studied them for 50 years. In fact, got all the books that had specialists' books in them, and combined them for the first composite book published in one of my early articles ( in 1895).

Martin Knight: So a contemporary of Abelson?

Victor Niederhoffer: In response to the always erudite Mr. Knight's query as to whether I a contemporary of
Abelson, I will violate our rules once more and hope that no one will ever follow in this tradition, be he Don Quixote, a composer or not and say: "Nay, I'm not a contemporary of Abelson. I'm much too old and
feeble for that. I'm a contemporary of Philip Carret, whose grandfather was born in the 18th century (albeit I regrettably do not plan to meet that god-fearing man in the next world.)

Peter R. Gardiner: About a year ago, curious about Labranche's ecomonics, I got out their 10K and took a look. If memory serves, they earned about 40% returns on equity for most years, and turned their total equity seven times A DAY, averaging about a cent a share per transaction. Given the leverage, the fluctuations, and the holes which get dug in their balance sheet every so often, it struck me as rich, but given the monopoly economics, and the dynamics well-described by Osborne, et. al.,modest for a monopolist.

As to the conspiracy theory advanced earlier regarding specialists "control" of price, to make such arguments convincing we must demonstrate that there are consistently huge opportunities for pure, non-legged, arbitrage between the electronic futures markets and stocks, or alternatively, that the positional advantage enjoyed by specialists is so large as to exert price control over the much larger, no specialist derivatives markets too.

As index arbitrage in almost all legged, and derivative markets dwarf stocks in size, I am,  respectfully, skeptical of the conspiracytheory or price control by specialists, notwithstanding Dick Grasso's compensation.

Brett Steenbarger: It is for others to disprove the analysis and refute the documentation. A good starting point for such analysis might be an examination of specialist short sales as a function of total and public short sales, a data set that goes back to 1943.  While the proportion of specialist to total short sales has displayed a downward linear trend over those years, an adjusted series finds that a 20 week average of specialist shorting reached a recent zenith in June 2001 and that we are at multiyear lows at present.  If the specialists have any degree of prescience, they are not anticipating market weakness at this time.

 My general impression, however, is that -- overall -- specialist shorting tends to lag rather than anticipate important market turns.

 An interesting candidate for identifying the motive force for large stock market trends, IMHO, is the impact of Fed Reserve behavior on the banking system.  Norman Fosback in his book Stock Market Logic was one of the first to suggest that "Expressed as a percent, the Free/Total Reserve Ratio provides an excellent measure of the extent to which banks are capable or incapable of providing the funds necessary for business growth and economic expansion."  Free reserves were consistently negative during much of the 1970s and early 1980s and have been pretty consistently positive since then.  I note that the most recent reading registered quite a jump in free reserves--the largest since reserves soared in the wake of 9/11.

John Lamberg:

> ...He's got you coming and going.  This is true of funds and is true of the public and is true of at-home traders...

> ...All this stuff about Excel, financial gibberish, accounting hokey, history of events, news, is delusion.

A student's observation:

 The House has an edge.

The House's mission is to relieve you of your wallet.

 Why is this a surprise?

 It seems to me that in successful speculation, the player’s goal must be to:

 1) define and truly understand your style (countist, macro trader, or simply an old geezer with a cane).

2) identify those times (in your timeframe) when the edge swings in the player's favor.

3) understand the expectation and underlying volatility and be capitalized for it.

4) realize you can be wrong, and/or that this edge will be gone/is already gone (ever-changing cycles).

5) exploit the newfound edge without mercy.

6) implement a system of psychological/money control to prevent yourself from giving the edge (and your money) back to the house.

7) Go To Step 1).

 In short, to beat the House one has to be act like the House.

Complaints to the House fall on very deaf ears.

Philip J. McDonnell: Peter makes an excellent point  regarding the derivatives market.  But specialists can trade derivatives too  - and they do!  

With respect to specialists' control of price it is a simple matter to prove that they control the open price.  Broadly speaking, the specialist's job, as defined by the exchange is to make a market and when required, to trade for his own account to even out order imbalances for the purpose of maintaining orderly markets.  

When we consider the huge build-up of overnight and weekend orders it is truly a rare happenstance that market orders to buy and sell exactly balance out.  So our intrepid specialist steps up and buys or sells to satisfy the imbalance.  But who picks the price at which they all buy and sell?

You guessed it!  Our fearless specialist simply picks the price at which all the market open orders will be filled.  You know, I think even I could make money if I could pick the price at which everyone was forced to buy or sell to me.

I agree with Peter that the conspiratorial tone of Richard Ney's work is a bit overdone.  As a capitalist I have to point out that the upstart Nasdaq has long exceeded NYSE in daily volume.  I believe free markets have come down in favor of the Nasdaq system of competitive market makers and will continue to do so until the NYSE either changes or fades away.  

In the meantime, when the specialist opens an NYSE stock I prefer to trade with him rather than against him.

Mark Serafini:
I could barely keep from fallin' off my chair after reading that they are paying Grasso $139M to remain the Chief Thief at the NYSE. It must be nice to run a monopoly of monopolies and get overpaid for the privilege
of doing so. That place (NYSE) is an antique...wrought with conflicts-of-interest and front-running. I've been employed (upstairs) by two of the largest specialist firms during my career and never have I met people who were more overpaid relative to their skills. That place needs to be shut down and replaced with a competitive auction
system. The specialist has such a time-space advantage it's ridiculous. Don't get me on a rant, but this payout is the proof-in-the-pudding. By the way, to give you all an insider account of how profitable these monopolists are. The last specialist firm I was employed by was profitable for all but one day during the year I worked there. That day
was the first trading day after the 9/11 nightmare. So they are pretty much profitable every day; that's about a billion std dev's from random. No wonder they all want to keep under the radar screen! LaBranche is
getting them all worked up right now. I've personally fielded many calls from lawyers and Wall Street reporters over the last few months in an effort to nail the specialist firms for front-running et al. The sun may finally be about to set on the easy money at the NYSE.