Technology Brings Trading Advantages to Individuals

Individual investors have significantly leveled the playing field with Wall Street professionals in recent years. But the biggest gains are yet to come.

So far, small investors are researching and trading stocks over the Internet, with information they couldn’t have gotten a few years ago. The cost of trading has plummeted. And some individuals even are prying open the previously cordoned-off world of initial public offerings.

Now, through what are known as electronic communication networks, or ECNs, and Level II computer trading screens, mainstream investors are slowly gaining access to dramatically advanced market data and trading tools formerly reserved for institutional investors.

Level II screens let investors monitor real-time trading patterns in Nasdaq stocks, while ECNs let them execute Nasdaq trades directly with other investors rather than through brokers, or “market makers.”

At the moment, ECNs and Level II screens are largely limited to Wall Street pros and to “day traders,” aggressive individual investors working on souped-up computer terminals at brokerages that have arisen to cater to such traders.

But within a couple of years, experts say, ECNs and Level II screens could be widely available to average investors.

“To date, this has been advanced technology applied to a niche market,” said Philip Berber, chief executive of CyBerCorp Inc., an Austin, Texas-based online brokerage and software firm. “With the Internet . . . we’re taking this previously niche technology to millions of Internet investors.”

For example, online discount broker E-Trade Group began offering Level II screens to its most active investors last month. Financial data company Telescan Inc. expects to roll out a feature next year on its popular WallStreetCity Web site, which lets customers simply hit a button to trade through ECNs rather than through regular brokerages.

To be sure, ECNs and Level II trading systems aren’t for everyone. For buy-and-hold investors who trade infrequently, they’re largely unnecessary.

What’s more, learning to interpret the complex data available on these systems is extremely difficult and requires a huge investment of time.

And despite falling prices, the services will initially remain too expensive for many investors.

But for the growing ranks of active traders--who live and die on the short-term, relatively small movements of individual stocks--ECNs and Level II screens could be very helpful services.

“The honest truth is that most individual investors don’t need it,” said Bill Burnham, an electronic-commerce analyst at Credit Suisse First Boston in San Francisco. “But if you’re [an individual] trader, it makes a big difference.”

Getting a Snapshot of Buy and Sell Offers

To understand the significance of Level II screens, it’s important to realize what drives stock prices up and down.

Over time, of course, a stock generally rises if the earnings of the company behind the stock are growing. The reason is that improving profits create buying demand, which over time overwhelms the supply of shares.

Supply and demand also are at work on an intraday basis. The greater the demand for a stock at any moment--for whatever reason--the greater the likelihood it will rise.

This may sound oversimplified, but on a momentary basis, stock prices are all about the number and size of buy and sell orders in the market.

Despite fancy stock charts and connections to Internet brokers, most small investors can’t see the total number of buy and sell offers for individual stocks at any moment, and thus have little insight into the immediate direction a stock is likely to take.

Some small investors see what are known as Level I data, which are a pair of quotes known as the “inside” prices for a stock.

The first quote is the “bid,” which is the highest price at which any Wall Street firm will buy shares from you at that moment. The second quote is the “ask,” which is the lowest price at which any firm will sell to you.

For example, the inside bid for a stock may be $100 and the inside ask may be $100.25.

That data may sound basic, but many investors can’t even get the inside quotes from Web sites and online brokers, which may give only delayed quotes showing the last price at which a stock traded.

Level II screens, by contrast, display not only the inside quotes for a stock but also a list of quotes from many other brokerages willing to trade the stock, and in specific numbers of shares.

Theoretically, then, an investor can look at the list and gauge momentary demand for a stock based on the potential buy and sell orders in the mix.

“The nice thing about Level II is that in just one snapshot of looking at a screen you should be able to assess the volatility of a stock,” said Michael Green, who owns the Santa Monica office of Landmark Securities, a day-trading firm.

The key with Level II, however, is knowing how to interpret the data. The screen consists of dozens of continuously changing numbers, making it virtually impossible for a novice to fully grasp what’s going on.

“I don’t think the public will be able to read Level II and understand it,” Green said. “In some cases, it’ll do more harm than good because they’ll get caught up in minutiae.”

Yet many brokerages that cater to day traders offer Level II quotes and ECN access to so-called remote customers who trade via computer from their homes.

For example, CyBerCorp customers who make 100 or more trades a month get free Level II access. But for those making fewer transactions, it costs $250 a month. However, CyBerCorp will introduce a lower-priced product early next year targeting more mainstream small investors.

On E-Trade, Level II was introduced Nov. 16 in a package of advanced services. Customers who make 75 or more trades a quarter get Level II and other services for free. But Level II is unavailable to those trading less often.

Analysts expect other brokerages to follow.

“I would be surprised if the majority of the top 10 online firms don’t offer some form of access to Level II quotes,” Burnham said.

Benefits of Knowing Level II Data

Though Level II data are complex, individual investors can benefit in several ways from the information, Green said.

One big benefit is being able to compare the inside quotes and the number of shares offered to buy or sell at those quotes with other quotes in the market.

For example, imagine that the inside bid for XYZ Corp. is $100 at 100 shares. That’s an offer to buy 100 shares from you at $100 a share.

Now imagine that the next-best bid is $99 and the third-best is $98. That the second or third bids are comparatively low could be a sign that demand for the stock is weak. If they were strong, the other bids might also be at $100, or close to it.

Investors also could benefit by knowing which brokerages are buying and selling, or offering to do so, Green said. For example, a big Wall Street firm, such as Merrill Lynch, aggressively buying shares could be an important show of support.

“The real insightfulness of Level II is watching a market maker really trying to take a position and doing it with size,” Green said.

In addition, an investor simply trying to determine how much of a stock he or she can buy or sell with relative ease, can gauge that by viewing the myriad brokerage orders that may not be for the best prices at the moment, but may be for more shares than are offered at the best prices.

ECNs Enable Better Prices for Traders

ECNs go hand in hand with Level II quotes.

ECNs are alternative electronic trading systems that let investors bypass brokerages and trade stocks directly with one another.

Eight of the nine ECNs in existence have been formed just in the last two years. They were spawned by a sweeping Securities and Exchange Commission rule change in January 1997 regarding handling of Nasdaq stock orders.

The new SEC rules stemmed in part from perennial investor complaints that their Nasdaq “limit” orders--which are requests to buy and sell stocks at specific prices--were being ignored by Wall Street.

Limit orders differ from “market orders,” which tell brokers to buy a stock at the prevailing market price. Limit orders often are used to trade in between brokerages’ quoted Nasdaq bid-ask spreads.

If the bid on a stock is $100 and the ask is $100.25, for example, a customer may place a limit order to buy or sell at $100.13.

Before ECNs came about, customers with Nasdaq stock limit orders simply submitted them to brokers and often didn’t get their orders filled. The customer’s brokerage knew the limit order existed, but unlike with exchange-traded stocks, it often was not “displayed” publicly to other investors.

ECNs arose to be limit-order matching systems. The investor putting in the $100.13 order could be assured of having that order displayed on an ECN, thus improving the chances of finding someone willing to take the other side.

On a Level II screen, ECN quotes are displayed along with regular brokerage quotes. That can enable individuals to trade directly with other investors at prices better than brokerages’ prices--instead of sending an order to a broker who forwards it to a brokerage market maker in the stock.

In other words, if one investor posts an order to sell XYZ at $100.13, another investor with a Level II screen and direct trading access not only sees that order but may press a button to immediately “interact” with it.

But note: Getting Level II data from a mainstream online brokerage doesn’t guarantee that an individual investor can send orders to ECNs.

That, however, is sure to come, many experts say.

“One of our most requested items is an electronic trading button on the site where they can just say, ‘Buy,’ ” said David Brown, Telescan’s chairman. “I’d be shocked if a lot of these major discount firms aren’t working on electronic interfaces to these ECNs.”

Times staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.

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Trading: Another Level

Here is a Level II screen showing detailed trading activity in Microsoft Corp. at one moment Monday. The top area shows basic data such as the ticker symbol, stock price and daily change. On the bottom portion, the rows in the left-hand column show the “bids,” or quotes to buy the stock, from various trading firms. The middle column contains the “asks,” or quotes to sell. The right-hand column lists the most recent trades.