Trading With The Specialist: The Smart Money Edge
Christopher
A. Tyler was an Equity Options Market Maker on the American & Pacific
Exchanges from 1992 to 1999. He traded off floor in his own proprietary account employing technical
analysis and option strategies in his trade decisions.
Since the
humble beginnings of the NYSE under a buttonwood
tree, one group of individuals has consistently outperformed the rest of the
investment community. These people are
called Specialists on the floor of the NYSE. (On
Nasdaq listed securities, they are called Market Makers, or Dealers, and perform
the same functions but through an electronic network, rather than on a physical
floor.) In this article, I will focus on the role of the NYSE Specialists, but
one group is easily substituted for the other as far as job functionality is
concerned.
The function of a
NYSE Specialist is to provide depth and liquidity in the securities
that he/she is assigned in times of imbalances in either supply or demand.
The Specialist executes this activity in his/her capacity as a Dealer. This
process is most often done at prices higher than the current bid/ask spread.
The Specialist is negating the
imbalance, but in doing so is assuming risk in his/her Dealer account, and
therefore the acceptance of this risk is usually transacted at a market premium.
The inverse of this process is when supply is greater than demand, and
the Specialist must purchase or go long the stock and accumulate inventory until
the imbalance is worked out. This
particular sequence would likely result in the Specialist purchasing shares at
prices lower than the current quoted market, and would likely continue until an
equilibrium between buyers and sellers could be established.
The Specialist also operates as a
Broker in his/her assigned stocks. When
the Specialist is not participating as a Dealer for his/her firm’s trading
account, his/her responsibility is to maintain a fair and orderly market as a
Broker in the product being traded. As a Specialist, this is his/her first
priority regardless of the capacity he is fulfilling (broker or dealer, or both)
at that time. Making sure that a fair and orderly market exists, in his/her
Broker capacity, requires that all competitive bids and offers in his trading
book, and those represented by other Traders and Brokers in the trading crowd
are executed according to price, size, and time.
The role that we as traders are
concerned with is the Specialist’s function as a Dealer.
Seats on the NYSE are currently trading near record levels, with the last
recorded sale at $2.5 million. In a
market environment that has left many successful traders scratching their heads,
or taking extended vacations, why is there a demand for seats on the floor of
the exchange? I know that I could elicit
many answers from the people buying up the seats in the first place, but most
likely, an educated guess would point towards the fact that the floor community,
where the Specialist reigns like royalty, is still making money.
As traders always looking for an edge,
we have to continually look for what’s working in the market and discard any
additional baggage, so to speak. Considering
the fact that for brokers, the commission business has all but gone the way of
the quarter slice of pizza, it’s not difficult to emphasize that if the
Specialists as a group are still making money, it must be primarily a function
of their activities as a Dealer.
The
Question Remains
Is there a way to capitalize on the
Specialist system’s apparent edge? I
believe the answer to be a resounding yes, but one must realize that in order to
participate, you as a trader must first know yourself inside and out. Financial
as well as mental constraints must be examined and acknowledged, before trading
profitably alongside the “smart money.†There’s a saying on Wall Street: The
market is an expensive place to find out who you are.
As we start to unfold some of the inner workings of the Specialists’
trading edge I think these words of wisdom will definitely ring true.
So how is it that the Specialists or
“smart money†always seems to land on two feet? Whether the markets are
going up, or down, this group is able to weather the storm as well as any
Captain riding out sometimes treacherous conditions.
First off, one must realize that the
Specialist is in a unique position. As
the primary marketplace for listed securities the NYSE Specialists probably has,
on average, the best knowledge of what the overall supply/demand conditions are,
at any given moment, in the stocks that he or she deals in.
Is this infallible, no, but it’s definitely privileged information that
comes with the responsibilities of being a Specialist.
This information might be in the form of resting orders on the
Specialist’s book, representing support and resistance levels away from the
current price, or it could be from working with the trading crowd, and the order
flow they represent. Either way, this is
a legitimate edge that as a Dealer, the Specialist can take advantage of, by
means of accumulating long or short positions based on supply and demand in the
marketplace (of course this Dealer activity must abide by the rules of the
NYSE).
The other edge, and equally important,
if not more so is the Specialist’s role as the buyer or seller of last resort.
This falls under the function of providing depth and liquidity in times
of supply/demand imbalance. Under
normal market conditions, in laymen’s terms, it allows the Specialist to buy
on the bid, and sell on the offer, and thereby profiting from the spread.
More importantly, to the trader wishing to unlock the “smart moneyâ€
edge, is the fact that in times of high volatility it allows the Specialist to
accumulate or distribute inventory at levels that would, under normal market
conditions, be considered at a huge discount (accumulating) or premium
(distribution) to fair market value.
But, what is fair value, other than
what the market is willing to bear? In
times of market panics, when fear or greed is running rampant, (by the way this
happens in both directions, for those of you who don’t remember the Fall of
’99 into the Spring of 2000), when liquidity has vanished from the markets and
the Specialists have little or no competition you can bet that “fair valueâ€
is at a huge discount. As the provider of last resort in times of high market
volatility, the Specialists have the ability to accumulate positions at extreme
price levels that are considered “fair value†temporarily, as other
investors are more than willing to exit their positions for piece of mind.
Now consider the statistic that the
Specialists on average, only participate in roughly 10% of NYSE volume (NYSE.com),
and one can surmise that a Specialist in his function as a Dealer, really is the
“smart money.†When one
realizes the fact that dealer activity is limited to this percentage level, and
the fact that this group of market professionals consistently makes money,
it’s safe to assume that their accumulation and distribution of inventory
happens at very advantageous price levels.
As traders, this means we would love
to follow in the footsteps of NYSE Specialists. We
might not have the same access to information or privileges that the Specialist
has as a direct result of his job description, but fortunately without having to
buy a seat on the Exchange, we can follow their activities as Dealers.Connors
VIX Reversal system.
The technology and access to the
markets has changed over the years, thankfully for the active trader.
What moves the markets, namely the constant cycle of fear and greed, the
frailty of the human condition, fortunately has not changed.
What this means for today’s technician is the ability to gauge market
extremes better than ever, and pinpoint with better accuracy what the Specialist
might be doing, thereby affording us the opportunity to trade alongside a
consistent winner.
In Times Of
Crisis
The tragic events of Sept. 11 will go
down as a day of infamy. The social and
economic repercussions were swift and severe, forever changing our country.
The financial markets were a mirror image of the investment community’s
anxiety and fear over the consequences and uncertain geopolitical future.yes”>
My intention here is not to downplay
this tragedy, especially since, as a former member of the American Stock
Exchange, it struck very close to home. The
point is that amid the ensuing financial chaos, the Specialists in their
capacity as providers of depth and liquidity, were able to ultimately profit
handsomely from other investors’ need to liquidate at whatever prices the
“smart money†would bear as buyers of securities.
From a technical perspective, the
price charts in conjunction with technical rules and sentiment indicators hinted
strongly at which side would ultimately prevail.
Of course, knowledge of the Specialist accumulating stock in of itself
doesn’t necessarily help us as traders. The
Specialist has much deeper pockets than most of us could ever fathom.
During a campaign of accumulation this process does indeed use, and need
this financial muscle. Otherwise, during the period of time that his campaigning
is taking place (dollar cost averaging) this provider of last resort would
become as helpless as those that he is profiting from.
Inevitably, as was the case during the
week after the markets reopened, anyone who bought the day the markets reopened
with the intention of turning a quick profit was most likely sadly mistaken.
If a trader was applying money management principals he or she could have
encountered many lumps in the form of stop losses before the eventual bottom,
and reversal in the markets.
The Specialist in his capacity
doesn’t have the luxury in times of crisis of stopping himself out with small
losses, but instead needs to focus on being able to accumulate at levels that
are attractive enough to withstand temporary punishment in the form of paper
losses.
The “smart money’s” accumulation might be an excellent starting
point for us, but for the trader to thrive and use this information effectively
requires using a technician’s arsenal.
The above charts demonstrate how a
trader could have effectively profited from knowledge of accumulation by the
“smart money.â€
The first chart is a four-year weekly
of the VIX. The
VIX represents equity option premium levels. The
higher the VIX, the more fear that’s hanging over the market.
The Connors
VIX Reversal strategy takes advantage of this contrarian sentiment
indicator, which is detailed in the Trading
Markets indicator section, but for illustration purposes in this article we
only need to recognize the fact that panic was definitely permeating the market.
The VIX hadn’t seen levels this
extreme since the Fall of ’98, coincidentally a prior market bottom.
Now take a look at the chart of Tenet Healthcare
(
THC |
Quote |
Chart |
News |
PowerRating). THC had all the trappings of a strong market performer prior to the
events of 9/11.
With the events of Sept.11, along with
any group that wasn’t related to a wartime economy, THC, which had clearly
been a strong RS stock, was taken down approximately 12 % during the next few
trading sessions. The up trend line was
broken, but the astute market technician reacting to the extreme VIX readings
and the technical picture of THC would have been alerted to a great opportunity
on the buy side.
On 9/21 THC made a perfect double
bottom test of the August low at 52.5, which also lined up within .50 of a 38%
Fibonacci Retracement (a tad bit over). THC
went on to score a 20% gain during the next month as the markets rallied off
their September lows. I quoted an old Wall St. adage earlier, about how the
markets can be a very expensive place to find out who you are. I’ll add to
that now by saying, “If you know who the Specialist is, and you know yourself
as well, Wall Street can be a very nice street indeed.â€