Today’s Trading Lesson From TradingMarkets

Christopher A. Tyler was an Equity Options Market
Maker on the American & Pacific Exchanges from 1992 to 1999. He is currently
trading off floor in his own proprietary account employing technical analysis
and option strategies in his trade decisions. Christopher is a member of
TradingMarkets.com.

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. In times that
demand outstrips supply, the Specialist is obligated to sell either his/her
firm’s (Limited Partnerships with financial ties to well-capitalized
clearinghouses/ financial institutions are standard practice) existing
inventory, or go short the stock. 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 money” 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 value” 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. As traders, we can make a
very good educated guess about when the “smart money” is mounting a campaign of
accumulation or distribution through price and volume charts (or statistics for
the mathematically inclined) and sentiment indicators, such as the

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. Once again, fear ruled on Wall Street.

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.
With their financial and market acumen they are able to do this, but for us,
just the knowledge of their accumulation is not enough. 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.”

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).
THC had all the trappings of a strong market performer prior to the events of
9/11. Tenet was in a strong up trend from the last week of May (the longer-term
trend began in July 2000), and had just made fresh 52-week highs two days
earlier.

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.”