Day-Trading Firms Create Smart Software to Seek Out Best Prices
The way average investors trade stocks is changing dramatically in the Internet Age, and the next major leap forward may come from, of all places, much-maligned day-trading firms.
A number of day-trading firms have developed “smart order-routing” technology that lets small investors bypass Wall Street middlemen and trade directly with other investors at potentially better prices.
The sophisticated systems scan various markets to find the best available prices for investors--the lowest price for a buyer and the highest price for a seller. The technology has the potential to save investors money by completing their trades faster than the typical online brokerage, and by eliminating the hidden costs of using intermediaries.
The firms, such as CyBerCorp.com, TradeCast Securities and Tradescape.com, hope the technology will help them advance beyond the world of day trading, the high-risk, rapid-fire trading game played by a relative few individuals.
The day-trading firms’ goal is to break into the ranks of mainstream online brokerages by luring the most active--and profitable--investors away from such firms as Charles Schwab Corp. and E-Trade Group.
The day-trading firms are not aiming at long-term “buy-and-hold” investors, nor would their services be useful for that type of investor. Rather, they are interested in investors who trade at least several times a week, and who would make use of their advanced services.
The new order-routing technology is a tacit acknowledgment of two facts about today’s market: The traditional method of trading stocks is being turned on its head by the emergence of electronic stock-trading networks that are challenging the established markets. And the changes--though ultimately beneficial to individuals--are nonetheless bewildering to many of them at the moment.
New electronic communications networks, or ECNs, have emerged in recent years to compete with the Nasdaq Stock Market and, increasingly, the New York Stock Exchange. ECNs, which match buyers and sellers directly, hold the promise of not only saving money for investors, but also giving them vastly more control over how their trades are executed.
ECNs handled nearly 33% of trading in Nasdaq stocks in the third quarter, new data show.
The downside, however, is that there are eight independent ECNs and they aren’t all linked to each other. So deciding where to route an order for the best price can be confusing and time-consuming even for active traders.
Individuals are “getting a market that is immensely complicated” and they have “very little guidance on how” best to trade, said David Whitcomb, chief executive of Automated Trading Desk, a trading firm in Charleston, S.C.
“And that’s what the intelligent-agent [software] models will do,” Whitcomb said. “They will do that thinking for you.”
“This is the first time you’re seeing an electronic agent of some sort, where you have technology which has been able to work the order for you,” said Omar Kathwari, director of Internet technology at Tradescape.com. “This really is the newest frontier of electronic trading because it simplifies the whole process. It lets people worry about making actual decisions about what they want to invest in . . . as opposed to, ‘How am I actually going [to trade?].’ ”
Trade Execution Is Hot Topic on Street
The issue of trade execution has become one of the most controversial on Wall Street. Federal law requires that brokerages and other intermediaries obtain “best execution” for their customers. That generally means that brokerages must ensure that investors receive the best price available in the marketplace at the time they submit an order.
But critics, including Securities and Exchange Commission Chairman Arthur Levitt, say small investors often don’t get best execution in the system by which stocks have traded for years, despite the many advances in trading technology.
To place an order currently, an online investor sends what amounts to an e-mail to a brokerage firm, which, in turn, often sends the order to a Wall Street “market making” firm that handles the actual execution.
Critics say there are many problems with this system.
First, brokerages often receive payments (typically a penny per share) from the Wall Street market makers for the right to actually execute small-investor orders, a controversial practice known as “payment for order flow.” That creates a potential conflict of interest if brokers route orders to receive the highest payment instead of where customers get the best execution.
Also, routing and rerouting orders is inherently slow, critics say. Especially in fast-moving markets, a customer who tries to buy a stock when it’s trading at, say, $30, may end up paying $30.50 or more because the price has jumped by the time the order is filled.
In a speech last week to securities industry executives, Levitt said it is becoming “increasingly clear” that investors are not getting best execution because of payment for order flow.
“I worry that best execution may be compromised by payment for order flow, internalization and certain other practices that can present conflicts between the interests of brokers and their customers,” Levitt said.
Upheaval in How Shares Are Traded
The focus on trade execution highlights another key point about today’s market for individual investors.
In many important ways, individuals in recent years have leveled the playing field with Wall Street by gaining access to many of the advanced tools that professionals use to buy stocks. They now have split-second news and financial data and are increasingly gaining entree to the once cordoned-off worlds of Wall Street research and initial public offerings.
But the way shares actually change hands is only beginning to evolve, and the greatest upheaval is yet to come, experts say.
Largely because it’s a behind-the-scenes process, few average investors pay attention to how their trades are completed, or whether they got the absolute best price.
But paying even a few cents more per share to buy 200 or 500 shares can add up and can more than offset the benefits of low commissions.
Between 3 million and 4 million U.S. households now trade over the Internet. But that number is expected to balloon to more than 20 million within four years. And as their knowledge of the market grows, individuals will learn to demand cheaper trade executions, said Greg Smith, online brokerage analyst at Hambrecht & Quist in San Francisco.
“Investors are becoming more sophisticated [and] learning about the whole trading process,” Smith said. “And as they become empowered, they will want new, better, smarter, faster tools.”
That’s where the day-trading firms hope to capitalize.
The firms give investors “direct access” to ECNs. The electronic networks have made a big splash on Wall Street, but they have been largely limited to professionals.
The day-trading firms let their clients send orders directly to ECNs, rather than relying on market makers to complete trades on their behalf.
But most individual investors are not day traders. And even the most active mainstream investors do not have the time or desire to hunch over a computer learning the intricacies of trading, including how to choose where to route every one of their trades.
The new smart-order routing software will do that for them. The technology scans the NYSE, Nasdaq and the ECNs to evaluate where an order should be sent based on the prices and execution speed of those systems at any given moment.
“What the smart-trading algorithms will do is to look at the market, keep looking at the market every second, find the best place for your order to be traded and then take your order and send it there,” said Whitcomb, whose firm also has developed the technology and is considering making it available to mainstream online brokerages. (The firm does not do business directly with individual investors.)
Said Greg Ferris, chief operating officer at CyBerCorp: “The bottom-line goal is to make a trading system so that your mother and my mother could use it.”
Smart-order technology may be most useful in fast-moving markets where stock prices are rapidly rising or falling.
In those situations, experts say, market makers sometimes slow down the process by which they fill small-investor orders at the time that customers need speedy executions the most.
The smart technology “will enable them to trade at really much better prices, particularly when they’re trading difficult stocks, stocks that are on the run,” Whitcomb said. “Because now, if you have the bad luck to put in an order to your discount broker on a stock that happens to be running for whatever reason, normally you’re going to get a really crummy execution.”
Interest in the new technology appears to be growing among individual investors. Last week, CyBerCorp.com was ranked the ninth-largest online brokerage firm, based on third-quarter trading activity, by U.S. Bancorp Piper Jaffray.
So far, smart order-routing technology is in limited use. And though prices for the service are coming down, fees can make it more expensive in comparison to most online brokerages--at least, not counting any potential price improvement in trading.
CyBerCorp.com’s low-end service, known as CyBerX, costs $14.95 per trade. But add-on features, such as news and charts, in a service known as CyBerX Plus, cost between $60 and $90 a month. And receiving more advanced stock data known as Level II prices can cost an additional $100 a month.
But as the technology advances, prices for smart order-routing capability are certain to drop, experts say. And eventually, many mainstream online brokerages are likely to offer such services.
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Times staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.
