Long gone are the days when a market maker could just sit at a desk and trade.
Some fundamental market changes and a hard-nosed business sense have forced over-the-counter traders to reduce the odds of taking unprofitable positions. More than ever before, sell-side traders are researching the stocks they trade.
"Nowadays, I would say I spend 30 percent of my work day doing research," said Nicholas Ponzio, managing director of equity trading at Jersey City-based Hill, Thompson, Magid & Co. "I make more effective decisions the more I know about a company."
While 30 percent may be high for others, most traders are studying research to perform effectively.
"A well-informed trader is a better trader," said Bill Rothe, head of equity trading at BT Alex. Brown in Baltimore. "A trader not knowing a stock's name is a thing of the past."
Generally, sell-side traders are short-term buyers and sellers. Traders typically do not make investment decisions based on long-term goals. Market makers need liquidity, order flow and a spread to profit in position trading.
But with tighter spreads and profitability declining on equity-trading desks, traders need to make more informed decisions to maintain a competitive edge. Studying research is now of paramount importance.
"Trading has gotten so much more competitive and difficult," said Peter DaPuzzo, president of equity sales and trading at Cantor Fitzgerald in New York. "Traders need to know their stocks so much better."
A 40-year Wall Street veteran, DaPuzzo recalled that in the past, OTC traders just came onto the desk and traded. But over the last ten years, several factors have increased an equity trader's responsibilities.
The Past
In January 1997, the Securities and Exchange Commission imposed the order handling rules, requiring market makers to publicly expose customer limit orders and display the best prices quoted on private trading systems.
Last summer, the U.S. stock markets reduced their minimum quote increments for all stocks from eighths to sixteenths.
With the new rules and smaller increments, Nasdaq spreads narrowed by about 30 percent. Consequently, many Wall Street desks saw profitability decline.
"Trading isn't quite as profitable as it used to be," said Bill Allyn, head of block trading at Los Angeles-based Jefferies & Company. "I think a lot of desks have had to reexamine the way they do business to remain profitable."
To combat declining profitability, major Nasdaq broker dealers stopped making markets in certain stocks. Last September, for example, global giant Merrill Lynch & Co. dropped more than 300 Nasdaq stocks, or 40 percent of the Nasdaq stocks the firm traded. Another Wall Street giant, Bear, Stearns & Co., trimmed its Nasdaq roster from 550 to 450. And New York-based PaineWebber reduced its Nasdaq count from 735 to 525 in 1998.
With trading less profitable, desks are more closely following the stocks they trade, hoping to minimize the impact of trading on a net basis, largely a result of less profitable retail-sized order flow.
"The industry has changed so much in the last two years, I think trading desks had to really study their operations to keep the business profitable," Ponzio said.
To be sure, the continuing flows of money into stock mutual funds and pension plans have cushioned the financial burden of unprofitable trades. Even so, there is little room for error as institutional trades often involve large blocks of stocks and put a firm's capital at risk.
"You just can't risk getting caught on the wrong side of a transaction," DaPuzzo added.
The Present
When Ponzio wants information on a stock he trades, he first checks a Bloomberg terminal to review activity in the issue, and scrutinizes information that may impact its performance.
Generally, most traders use the many market-data tools available on every trading desk.
"We avail ourselves of everything we subscribe to," Rothe added. "We have a Bloomberg machine running, a Reuters link, and CNBC and CNN on the televisions all the time. If news breaks on a company or a stock, we want to know about it as soon as we can."
Most desks also subscribe to a number of industry newsletters and magazines. Robert Race, an equity trader at Winchester Investments in Overland Park, Kan., subscribes to a range of trade publications. He also heads to a public library a few nights a week to read about companies and the markets in various newspapers and magazines. Race estimates he does market research at least two hours every day.
"When I first got into the business, traders just came in the morning and traded," Race said. "But the business has absolutely changed, and you can't really get away with that anymore."
Aside from making a market in 25 stocks at Winchester, Race also manages his own portfolio of investments. "I need a feel for the stocks I want to trade, because my own capital is also at stake," he added.
Because Nasdaq does not have a physical trading floor, market makers still use telephones to work on executions with other traders, despite their desks' computer interfaces. Ben Marsh, managing director and head of OTC trading at Adams, Harkness & Hill in Boston, will ask other traders what they know about a stock.
"You have to use any bit of leverage you can to improve your performance," Marsh said.
Because Hill, Thompson, Magid makes markets mostly in non-Nasdaq OTC securities stocks listed on the OTC Bulletin Board and the pink sheets Ponzio can't always find the stocks he trades covered extensively in the media. He regularly invites a company's executives to his office for meetings. Ponzio also tries to visit companies close to his Jersey City office to look more closely at operations.
Most large market-making firms have highly-focused research departments staffed by analysts covering specific industry sectors. A trading desk will usually only make markets in stocks covered by its research department, relying on that research to stay informed on its stocks.
Most trading desks hold morning meetings to prepare the traders for that day's session. The meetings update the traders on information that may affect a specific stock or the market on that day.
During the day, if a stock begins performing irregularly, or a trader is presented with an unusual situation, the desk may call a research analyst to inquire about a stock.
"I'll ask an analyst during the day to fill me in on why a stock is moving the way it is," Marsh said. "He can usually tell me if it would be a mistake to take a short position, or if he thinks a stock has hit its bottom and won't drop further."
Many industry observers question whether research departments can truly provide objective analyses. These observers have criticized large firms for tailoring research to the goals of their investment-banking and sales departments.
"I don't want to get too opinionated about a stock I'm trading," Marsh said. "I encourage my traders to keep up on our research. But I also want them to keep a clear head, and to try not to be clouded by an analyst's opinion."
He stressed that his firm is a research-driven investment bank, dependent upon valuable, unbiased research to draw business. But he said that on Wall Street, objective research is not always easy to find.
Mark Kaicher, head trader at Buckingham Research Group, a New York-based firm making markets in 100 retail, cable and airline-industry stocks, similarly stressed a need for balanced research to keep decisions objective.
"With my retail stocks, I rely on our analysts, but I also go to a few stores now and again to check out how the products are packaged, and how they sell," Kaicher said. "I synthesize a variety of information to make the most objective decisions I can. The business is too competitive not to."
Kaicher also noted that trading has become a more technical profession in recent years. Before, firms would hire traders right out of high school, he said. Today, Kaicher added, many desks are hiring Ivy League graduates with master's degrees, and the learning curve in trading has risen as a result.
"It used to be more seat-of-the-pants trading," Kaicher said. "Now, you have to do your homework, and the business is so much more technical."
The Future
The move by market makers to more closely study the stocks they trade has been voluntary thus far. But new rules, proposed by the National Association of Securities Dealers and generally endorsed by the SEC, may leave market makers with no choice but to research non-Nasdaq OTC stocks.
At a meeting in February, the SEC approved a measure to increase the responsibilities of broker dealers quoting small, thinly-traded stocks.
At issue was a proposed requirement that broker dealers research and make available information on companies they quote on the pink sheets and the OTC Bulletin Board. At present, only the broker dealer initially quoting an OTC stock is required to review the issuer's financial data.
Also in February, the NASD released a list of companies that did not meet new Nasdaq listing standards. An industry source estimated that more than 2,000 companies would be forced to delist to the OTC Bulletin Board and the pink sheets in the wake of the new standards. With more OTC stocks not traded on Nasdaq, the OTC Bulletin Board and the pink sheets would see an increase in volume, experts say.
The OTC Bulletin Board and the pink sheets are generally perceived to harbor some questionably-listed companies. The OTC Bulletin Board is owned by the NASD, but is not held to the agency's listing standards. The pink sheets traded manually and named for the color of the sheets listing their price quotes are owned and operated by the New York-based National Quotation Bureau.
In May, the NASD approved its own set of rules requiring broker dealers to review and disclose financial information before recommending an OTC security to a potential investor. The proposal will also permit only those companies reporting current financial information to the SEC and banking and insurance regulators to be quoted on the OTC Bulletin Board.
At press time, the NASD was preparing to send the proposal to the SEC for approval.
Broker dealers contend that the proposed rules would place an unfair burden on small-cap market makers, with fraud liability bogging down trading desks.
"Market makers should not be held responsible for information because they trade OTC stocks," Ponzio said. "We don't mind doing research, but we shouldn't have all of the reporting responsibilities on our shoulders."
Ponzio's firm, Hill, Thompson, Magid, could be hit hard if the SEC approves the NASD proposal. And approval seems likely.
Tony Broy, Hill, Thompson, Magid's president, fears that many market makers would be forced to abandon the OTC market if the NASD rules are passed. "If those rules pass, every market maker would have to get out of the OTC Bulletin Board market," he said. "There would be a real bleed effect back to the NASD because a lot of stocks would be abandoned. And if stocks are traded away from a reputed exchange, fraud could be rampant."
Ponzio suggests the NASD and the SEC collaborate with the trading community to create a central location for company information.
"If someone, anyone, does due diligence on a stock, it should go to one central location to cut down on duplicating efforts," he said. "That way, investors, regulators and professionals would all know where to go to get company information, and responsibility wouldn't fall unfairly in one place."
The Constant
Meanwhile, market makers stress that skilled trading is still the most important responsibility of traders, despite the surge in research on the desk.
"Research definitely plays a bigger part in trading, and it plays a part in decision making," Rothe said. "But it only plays a part. You have to keep that in mind."
Marsh agrees. "I use research to my advantage, but I try not to be too smart with it," he said. "I'm not investing, and I have to remember that. I'm trading."
