Knight Trading

(NITE)

is depending on the same thing that sapped its third-quarter earnings to aid its fourth-quarter income -- the

Nasdaq

.

After

announcing weak third-quarter results Wednesday, the company said in a conference call that it could earn 30 cents to 40 cents in the fourth quarter, but only if the Nasdaq rose an annualized 5% to 10% in the period.

The range put forth by CEO Kenneth Pasternak still is lower than the 50 cents a share the company earned in 1999's fourth quarter, but it's much higher than the 16 cents a share Knight reported Tuesday for the third quarter. Knight blamed the puny results on a change in trading habits by the individual investors who it executes trades for. Instead of trading high-growth or tech stocks that Knight says are very profitable for it, investors have been sticking with more conservative issues, including blue chip stocks such as

IBM

(IBM) - Get Report

.

Knight makes more money on more obscure, less-liquid stocks because it can step in as the middleman in the transaction. For instance, after buying a stock, it was often able to turn around and sell it at a profit. This was particularly true with the illiquid stocks from tiny companies that were in favor early this year. But with more liquid stocks, there's little need for Knight to intervene in the trading process and orders from buyers and sellers simply cross each other out.

Conservative Behavior

Pasternak said that conservative investing behavior could become even more common if the Nasdaq continues to slide and investors are further spooked. This is important for not only Knight but also its online brokerage clients like

Ameritrade

(AMTD) - Get Report

that send orders to Knight. Online brokers don't care what type stocks investors trade, but they do care when trading volume falls.

Here's how Pasternak says trading has played out so far. As the Nasdaq moved toward 3000 from 5000 during the past six months, the mix of stocks has shifted toward blue chips. Therefore if the Nasdaq falls to 2500, that would probably mean a further narrowing to the kinds of stocks that are less profitable for Knight. "In a down market, investors are more likely to take a more conservative investment thesis," Pasternak explained.

That clearly translates to the bottom line. During the quarter ended Sept. 30, Knight brought in $165.5 million in trading revenue, down 42% from the previous quarter and up 13% from a year ago. Meanwhile, earnings per share fell to 16 cents, a decline of 70% from the previous quarter and 27% on the year ago quarter.

Expected

Wednesday's weak earnings announcement was far from unexpected. Knight let investors know the first week of October that its earnings would be between 13 cents and 16 cents in the third quarter instead of the 31 cents a share analysts surveyed by

First Call/Thomson Financial

expected, or the 22 cents to 27 cents a share the company said it had expected.

Knight's lower trading activity underlines a phenomenon occurring among the customers of its large clients including Ameritrade and

E*Trade

(EGRP)

. E*Trade is due to report its results Thursday morning while Ameritrade is expected to report next week. Expectations for both are low, given what investors have heard already this week.

Another competitor,

Charles Schwab

(SCH)

, which runs both an online broker and a Nasdaq market maker, reported earnings per share of 12 cents Tuesday, in line with expectations.

Wit Capital

(WITC)

, meanwhile, a tiny online broker that's swapping brokerage customers for online investment banking activities with E*Trade, reported Tuesday an operating profit of 1 cent a share, better than the expected loss of 1 cent a share.

But if investors in these trading-sensitive stocks are any indication, confidence in a fourth quarter rebound is pretty low. Knight fell about 2.4% Wednesday, while E*Trade was off 4% and Ameritrade was down 1.4%.