Beware of Your Trading Adversaries : Part I, The Specialist by Ron Worley Senior Analyst
It never occurs to many investors to consider the folks involved in their trades as adversaries. They assume commissions to be their biggest cost in a trade.
Yet, untold amounts of money are lost for this reason. One would think brokerages make most of their money from commissions. How can a brokerage make a profit from $5 commissions? The answer lies in understanding the profit motives in transactions of those in the securities industry.
The Specialist: Specialists are charged with creating a "fair and orderly market flow" in exchange listed stocks. It may be somewhat orderly, but it's a stretch to call it fair.
Most stocks have one specialist who, thus, "specialize" in a stock and know everything about that stock. Huge volume stocks like IBM may have 5 or 6 specialists. A specialist receives news before anyone else. They have the order book showing everyone's hand, somewhat akin to a card dealer seeing what everyone is holding and then being allowed to deal what he/she chooses. They have a sense of the psychological state of the market and the trading floor at all times. They control the prices for buying and selling. If there is a sudden surge in buy or sell orders without people on the other side of the trade, the specialist is required to personally buy or go short to keep the market flow "orderly". In return for taking risks, they may (and do) trade for their personal accounts. Fair's fair, right? Well,...not exactly.
Specialists may have trading in a stock halted because of "order imbalance". This means that instead of risking their personal funds to balance the orders, they stop trading and reset the bid and ask to their advantage. To wit: Some years ago, I had a tidy profit in this private prison stock which had advanced to 48. To follow the rules, I dutifully moved my stop loss to 46. Then, news was announced, intraday, that a popular newsletter author was touting the stock while selling off his position on the sly. Being the first recipient of this little pearl, the specialist stopped trading to assess the inevitable wave of sell orders and reset the bid and ask in the 41 and change area, gapping through all the stop orders and picking up those stops at bargain prices. You know what happened next. The stock's price was then "adjusted" upward and was sold with a smile to the new buyers, making a handsome profit for the specialist. Those investors with the higher stop orders simply got their pockets legally picked. A "fair and orderly market"? (Sell stop orders are triggered at the first bid price that touches, or is posted below, your stop. Limit stops say that you want to sell at X price, but if it is triggered at a lower price, that is unacceptable.)
The preceding case is an extreme example and it doesn't happen that often, but it illustrates the advantage of specialists and how they can use it to rob investors.
So, how do you protect yourself from the specialist?
Be aware that the specialist wants you to buy and sell according to his/her needs. Therefore, be wary of price moves (particularly in the noon to 2:30 Eastern time frame) that have no news and are moving up or down on low volume. This is a favorite time frame for specialists to make sucker moves because trading is thin. It is an unspoken rule that floor traders don't fade a specialist's sucker moves due to the possibility of retaliation on other trades. Off-floor traders can fade a specialist sucker move, but don't try this unless you're an experienced day trader. Be wary of "breakouts" on no news or low volume. Specialists can read charts and like to sucker in those who will buy any break.