Stock Trading: a market minute on NASDAQ Now we going to take a closer look at how stock trading is done. what's the nitty gritty of what's going on in that electronic shark tank known as NASDAQ? It's a lot like an auction such as ebay, but a lot slicker and faster. NASDAQ stands for "National Association of Securities Dealers Automated Quotation", and started in 1971 way before the internet, and trades many thousands of stocks and an alarmingly high rate. First let's introduce the players in this simplified picture: Market Makers You can think of these as the sellers on ebay. Except not only do they sell, they also buy. OK, so it's more like craigslist. (More correctly, they are firms like Merril Lynch that have people working for them that do the fun stuff I'm talking about.) Market Makers "make market" in certain stocks, like Intel, Cisco, or Apple. They have a license to offer stock or bid for stock both at a price of their choosing. They have a cache of shares to sell people. They take a risk by doing this, but they tend to make huge piles of dough so don't feel too sorry for them. Traders These can be pretty much any Joe Schmoe who can pay to get hooked up to NASDAQ. This is not quite the same thing as buying stock over Etrade or Charles Schwab. They're often doing the stock trading with the Market Makers, and I'm not talking about going through middle-men. Day traders can get pretty direct hookups to NASDAQ to trade. Of course you'll get charged money for this, of order a few bucks. This can be a problem if you trade like maniac, but Wall Street can do trades for a lot less. So what you have is a huge market place of people buying and selling thousands of different stocks, each one trading millions of dollars in a matter of minutes (or even seconds). Let's concentrate on one stock, say Cisco, (which has the ticker symbol CSCO). At any one time there are market makers trying to buy or sell stocks. Why? Sometimes because they think they can make money by buying low and selling high, but often it's because they have an institutional client such as a mutual fund that has decided that they need to buy more CSCO or unload CSCO, based on their own ideas of what to invest in. So suppose Bill works for a mutual fund and wants buy shares of CSCO. Say each share trades at $30.1. So he calls up his pal Fred, who is a market maker and says "Hey Fred, can you please get me $50,000 of Cisco?". Fred then tries to get these for his friend, ... for a modest fee. Of course Bill wants to get them at the best price and that's why he goes to Fred who's well versed in the art of market making. Fred looks on his monitor and sees the current montage of the market showing the stock market quotes the market makers are making. It looks something like this (slightly simplified): . . . NITE 30.6 2000 MLCO 30.5 500 GSCO 30.4 1000 BEST 30.3 1000 HRZG 30.2 1000 INCA 30.1 5000 . . . In each line, the first column tells you the name of the market maker (e.g. the company Fred works for). For example MLKO is Merril Lynch and GSCO is Goldman Sachs. The second is the price per share that is being offered, and the third is the volume (or the "depth"), that is, the number of shares that are being offered. The market makers above the blank line, GSCO, MLCO, and NITE, are offering to sell their shares. The ones below the blank line, BEST, HRZG, and INCA, are offering to buy shares. For example BEST is offering to pay $30.3 per share for 1000 shares, but no more than that. GSCO is offering to sell 1000 shares at $30.4 per share. These numbers change very quickly, as traders snap up these at a dizzying pace, or the market makers change their quotes depending on the strategies that they're following. In this case you say that the "bid", how much people are willing to bid for a share of CSCO, is 30.3. And the "ask", how much people are asking for a share, is 30.4. The difference between these two numbers, the ask and the bid, is called the "spread". If you buy 100 shares of CSCO and then immediately sell it, then you naively expect, see below, expect to lose $100 \times \$0.1 = \$10$. So Fred now has to get 50,000 shares. So he could just go ahead and buy up anything that's out there in one go. But then he's be paying a lot more than the going rate. That's because once he's gobbled up GSCO's 1000 shares, the best deal is offered by MLCO, and the ask has moved to 30.5: . . . NITE 30.6 2000 MLCO 30.5 500 BEST 30.3 1000 HRZG 30.2 1000 INCA 30.1 5000 . . . he has to pay that now. Very quickly, he's paying a lot more than the going rate. So he can buy the shares much more slowly so that the prices have a chance to come down before he gets more. That way he appears to have a smaller effect on the prices. Also people don't know Fred has to buy 50,000 shares. If they did, this would cause prices to rise so he doesn't want people to know what hand he's holding. The way this is all done is tricky and takes a lot of experience. I won't go into that now. Similarly if Jack wants to sell 100,000 shares of CSCO, he will call up a market maker to sell them for him and this will have the effect of lowering the prices. This sort of stuff goes on all day and this by itself causes prices to fluctuate quite a lot. But that's not the only thing that does. People watching these screens think they can figure out what's going on and thereby make money by buying low and sell high. Their activity also influences stock prices, causing it to fluctuate even more. For example if Fred does try to buy up shares all in one go, people quickly notice that the price is going up, and hop on the bandwagon, trying to buy early on before the prices go up, thereby making a profit. The situation is further complicated by the fact that this isn't the only screen that needs to be watched. Nowadays there are many ECNs, Electronic Communication Networks, which themselves act like little NASDAQs with slightly different rules. People can place or take orders from them also, and their best prices are displayed on NASDAQ. For example "INCA" above stands for Instinet. There is also Island, Archipelago, and Brut, to name some other big ones. But I don't want to go into that level of detail as it doesn't really add much to the main points I'm making here. All this activity causes to make the look market look extremely chaotic, and in fact random, although the ups and downs in the prices can be traced to the kind of scenarios I just gave. The price of a stock goes up and down and up and down hundreds of times a day. The starting and ending price of many stocks in one day often differ by about 3%. The amount of fluctuation is refered to as the volatility. The fact is, the market is extremely unpredictable. How unpredictable? Very very very! I'll explain why.