Online Brokers Do Some Penny-Pinching - TheStreet

Professional traders and those who work at institutions and hedge funds have long used sophisticated software tools to help them receive quality executions. Now one of those tools has gone mainstream.

Earlier this week, online brokerage firm

Datek announced that customers could enter orders at one-tenth-of-a-cent increments. That's instead of the increments of a penny or more brokers typically allow.

What does this mean, exactly? Let's say the best available

bid price for XYZ stock is $10.37. You enter a

limit order to buy XYZ for $10.371. That makes yours the best bid price at that moment, which puts you at the head of the line. The next person to send off a market order to sell XYZ shares will be selling those shares to you. That's because a market order always executes at the best available price -- which in this case happens to be your bid.

A Possible Boon to Daytraders

Jumping to the head of the line can be a big help to daytraders who rely on being able to buy and sell shares faster than their cohorts. So for daytraders, Datek's penny-shaving orders should make possible some interesting strategies.

For example, suppose you've been watching the charts, and you've noticed that XYZ's price has dipped slightly in trading over the past few minutes. You believe a short-term reversal is about to occur. That is, you think the stock will start to trade up again, if only by a few pennies.

Tiny price fluctuations like this occur throughout the trading day. To capitalize on them, you want to pick up as many shares as you can, as quickly as you can, at more or less the current price. Then you'd wait for the rise before selling. Using a penny-shaving order, you can continually jump to the head of the line and buy the shares as quickly as they become available from fresh market sell orders.

Using this same technique, you could also sell the shares quickly or sell them short if you sensed XYZ's price was about to decline.

Penny-shaving orders might also be useful to a type of daytrader called a scalper. Scalpers make their living on the smallest of price moves. To make their trades pay, they often move blocks of 1,000 or more shares. And they may grind out essentially the same trade dozens of times per day. Penny-shaving orders would allow them to buy at, say, one-tenth of a cent above the current bid, then immediately sell at one-tenth of a cent below the

ask price. In this way, they profit from the spread, which is the difference between the bid and ask price.

Island Time

According to a Datek spokesperson, penny-shaving orders can only be made using the brokerage's direct-access platform, Datek Direct (I reviewed Datek Direct in a

column I wrote earlier this year). Also, these orders can only be routed to

Island

, a private trading network, or ECN, which is affiliated with Datek. This has some drawbacks, which I'll discuss below.

However, once the order arrives on Island, it would likely constitute the best bid or ask price, which means it also will be displayed on the

Nasdaq

Level II order book as the representative best price from Island. The Level II book lists the best prices from all trading venues, including all the ECNs and market making firms. (FYI: Market makers are sanctioned by the Nasdaq to buy and sell shares of a particular stock in order to provide liquidity to the market.)

There's a disadvantage to listing orders only on Island, however. True enough, the ECN accounts for something like 16% of the Nasdaq's overall trading volume. And the best price on Island will closely match the overall market's best bid or offer. But Island is still an island unto itself. And in a fast market, better prices can quickly emerge from other ECNs and market makers. That would cause your Island bid to move down the list on a Level II display. If that were to happen, you could re-enter the order manually. But that would take up precious seconds and might force you to exit the trade at a slight loss.

Living in a Decimal World

The reason Datek allows penny-shaving orders to be routed only through Island, I'm told, is that decimal trading is still fairly new. Not all brokerages and ECNs are able to accept orders in fraction-of-a-penny increments, even though you should still be able to receive an execution if, say, your buy order hits another sell order that's been priced in tenths of a penny. Island, as it turns out, jumped on the decimalization idea early and retooled to accept tiny price increments. This should pay off for Island in the form of increased order flow.

Blackwood Trading, a brokerage that caters to serious daytraders, hedge fund traders and the like, has developed trading software with a couple of intriguing workarounds for penny-shaving orders. While the Blackwood platform still makes use of Island, it also lets you route orders to the market quickly, if need be. For example, when you enter an order, the software first determines the best current price on Island. Then it adds half a penny to that price. So, as with Datek, you're moved to the front of the line. But in this case it's automatic.

Yet another Blackwood order type, called "Go For It!" routes to Island and tops the current best prices by half a cent. However, if the order doesn't execute on Island, a software program called Hunt kicks in and attempts to find a price match for your order by rapidly scanning the prices fielded by other ECNs and market makers.

What About Volatility?

If other brokerages take advantage of decimalization and begin implementing order-entry technology like that you find at Datek or Blackwood, it's possible that trading might actually become more volatile. Here's how: If three traders unbeknownst to each other all set their software so that it continually adds a fraction of a penny to the best available price, the traders' orders would repeatedly jump in front of each other, and thus drive the price of the stock up. At least that's what would happen if no one took the other side of their trades.

Fortunately, so far it appears that decimalization is having just the opposite effect. While volatility has not increased, quoted spreads on many stocks have fallen by something like 50%, according to a recent Nasdaq

report.

Mark Ingebretsen, author of the newly released book,

The Guts and Glory of Day Trading: True Stories of Day Traders Who Made (or Lost) $1,000,000, has written for a wide variety of business and financial publications. Currently he holds no positions in the stocks of companies mentioned in this column. While Ingebretsen cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

mingebretsen@yahoo.com.

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