Nasdaq Dealers Play Wild Cards

Did you dump Nasdaq stocks at Tuesday’s market low, only to watch them rebound minutes later?

If so, you have lots of company.

Panicked sellers descended on Nasdaq with a vengeance that drove the composite index down nearly 14% by mid-morning. Then just as quickly, the index shot up in the afternoon to reclaim 500 of the 575 points shed only hours earlier.

Even in a market where volatility has become commonplace, how could Nasdaq stocks plunge so sharply one minute only to soar the next?

Part of the answer is simply investor psychology. As individuals watched Nasdaq’s onetime highfliers crumble, some raced to unload shares, exacerbating the decline. Once the market turned, buyers rushed back in--almost as frantically. Greed overcame fear.

But there might be another factor: the way stocks are traded on Nasdaq, which some critics say may benefit Wall Street firms at the expense of individual investors, especially in volatile markets.

Unlike the New York Stock Exchange, where trading in each stock is controlled by a single “specialist” responsible for maintaining an orderly market in its shares, Nasdaq has a “dealer” system. In the electronic Nasdaq market, dozens of big Wall Street firms, known as dealers or market makers, post prices at which they will buy shares of a stock from, or sell them to, investors.

Theoretically, market makers compete to offer investors the best price on trades. But when a stock price is falling during a turbulent market, market makers don’t want to buy shares because they fear the price could sink lower.

To avoid having to buy a falling stock, market makers drop their “bids,” the posted price at which they’re willing to buy shares.

If a stock is trading at, say, $50, a dealer might bid $48. The intentional posting of such an noncompetitive price virtually assures that the firm wouldn’t have to actually buy the shares.

“Market makers don’t make money by buying stocks when everybody wants to sell, so they just kind of fade away,” said Wayne Wagner, chief executive of Plexus Group, a stock-trading consulting firm in West Los Angeles.

Typically, market makers won’t aggressively bid for stocks again until institutional investors such as mutual funds send in buy orders on stocks that have fallen sharply, experts say. At that point, market makers seek to scoop up shares being unloaded at rock-bottom prices by panicked investors, then sell them at a quick profit to institutions.

Thus, for smaller investors, the risk is getting caught in the panic and selling at the lows, only to see the market rebound soon after.

Such a scenario has for years infuriated some active individual investors, who believe market makers lower prices intentionally to scare individuals into selling at bargain prices. Wrote one investor on an Internet message board Tuesday: “It came down because that’s what they wanted, so now they can make fat profits. Disgusting, isn’t it?”

Some experts admit privately that they suspect market makers push down bid prices to rattle small investors. However, many others dismiss the notion.

The only incentive for market makers to do that would be if they could clearly foresee where stocks are headed, a clairvoyance they obviously don’t have, said Harold Bradley, head of strategic investments at American Century mutual funds.

“Who in the world would have known in mid-morning that the market would [rally so strongly],” he said.

The real problem, Bradley said, might be that many individuals use “market orders,” which instruct brokers to buy or sell at a prevailing market price, rather than “limit orders,” which specify a price. By not designating a price in a market order, investors run the risk that their orders will be filled at significantly different prices from what they expect.

“Investor behavior is far more to blame than is [market maker] behavior.”

Even so, individuals might suffer in a turbulent market because market makers have a built-in conflict of interest in how they handle small-investor orders, said David Whitcomb, chief executive of Automated Trading Desk, a trading firm in Charleston, S.C.

When market makers receive sell orders from individuals, they have two options: They can either fill the order themselves by using the firm’s own money to buy the shares, or they can send the order to other firms where it may be filled.

But because market makers always seek to buy shares cheaply in the hope of turning around and selling at a profit, they might be tempted to delay sending out individual investors’ orders, Whitcomb said. Instead, they might hold on to the orders.

If institutional investors then submit a batch of buy orders, indicating that a stock is likely to head up in the short term, dealers can quickly buy shares on the cheap from small investors and turn around and sell them at a higher price to institutions, he said.

“There’s every incentive to execute customer orders very slowly because every second of delay . . . is a second where you may have the option of filling that order at a guaranteed profit,” Whitcomb said.

In that scenario, small investors might suspect that they’ve gotten bad prices, but they can’t prove it.

“A customer is going to call the help desk at a retail brokerage firm and say, ‘I was watching the market trade for five minutes today while my order to sell Microsoft was sitting at your firm and didn’t trade,’ ” Whitcomb said. “And the help desk is going to say, ‘Well, that’s just the way it is.’ ”

Times researcher Kathleen Brady contributed to this report.

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Source: Bloomberg News