After a week pressuring new highs the Dow has returned to support that has remained firm for the last seven months. Is this another dip to buy or the beginning of the long awaited correction? The Dow lost nearly 1% for the week and that is the first time this year and only the second time since August that this has happened. We had dips but they were either mixed with gains or spread over a two-week period rather compressed into one week. In reality that statistic is just a timing anomaly and nothing that investors should worry about. The worry will come in if the current support at the 30-day average at 12616 breaks and is then followed by a break of the 50-day at 12539. Should those events occur this commentary would take on an entirely new focus.
Dow Chart - Daily
Nasdaq Chart - Daily
Friday was a non-event for economic reports and for trading in general. The only report was the monthly mass layoffs, which rose to 1,237 layoff events impacting 134,984 workers. The sector with the largest losses was still manufacturing with 32% of the total layoffs and 40% of employment claims. Transportation equipment (automakers) led with the largest losses. Continuing restructure announcements suggest that this trend will continue through 2007.
Next week we will see a sharp spike in economic reporting activity with numerous high profile reports. The highlights will be the GDP and PMI on Wednesday and the ISM on Thursday. The GDP revision is expected to drop to show only 2.5% growth from the previously reported 3.5% level. That report has the potential to move the markets if it shows stronger or weaker growth than expected. The Chicago PMI report is expected to show a rebound back over 50 from last months 48.8 reading, which was the lowest level since April 2003. A sharp drop in new orders had led to the sharp decline in the headline number. The ISM index fell into contraction territory in January at 49.3. Any number under 50 represents economic contraction. The inventory component fell to 39.9 and the lowest level since early 2002. Weakness in other components suggested there was further weakness ahead. These reports should be the market movers for the week but the rest of the reporting calendar contains additional reports that could further cloud the economic forecast.
Impacting stocks on Friday were rising oil and commodity prices and further problems in housing and subprime loans. The fallout in the subprime mortgage market is making it harder for weak buyers to snap up bargains in the depressed housing market. It is also making lenders all the way up the food chain more cautious in their lending practices. The subprime problem appears to be impacting loan approvals and rates higher up the credit profile. Borrowers with medium credit are also finding it harder to get favorable loans and high loan to value promotional loans have disappeared from the landscape. Borrowing down payments is proving increasingly more difficult. Foreclosures are rising and a new trend is forming where loans default after only a few months in force rather than the historical average of just over two years.
The damage to stocks of subprime lenders has been extreme with worries about further problems ahead. These subprime lenders sell off their debt and fears are growing that major buyers may back off and leave the finance companies holding the debt and unable to fund any more deals for lack of capital. There is also a fear that already eroding profitability will be further hurt by rising costs to sell those loans. Historically subprime loans only account for 10% of the $9 trillion mortgage market. Over the last two years that number had risen to 20%. This could be due to the reclassification of credit worthiness and broadening restrictions on what qualifies as a marginal credit. The challenge is even larger when you consider the majority of those subprime loans were ARMs, negative amortization loans, interest only loans and loans for 100% of the property value. The worse the credit the more creative lenders became to overcome the obstacles to lending. That came back to bite those lenders in a big way. Over the last several months 22 subprime lenders have either shutdown or filed for bankruptcy. The risk spreads for getting deals sold has jumped nearly 1400 basis points. In the banking world that is an obscene rate increase and hardly one that would not cause dire consequences to any company in the subprime business. There are rumors that the mortgage debt is being traded at 40-50 cents on the dollar by firms struggling to avoid default and liquidation. Who is buying that debt is the real question? This is what the market is worried about. Who has exposure to this growing problem without Wall Street knowing about it? Over the last week Novastar Financial (NFI) fell -51% after the Wall Street Journal warned that the continued meltdown in subprime could lead to a bigger problem in the financial sector. NFI is down -71% since mid December when the problem began to worsen. LEND lost -12% and NEW -19% in just the last week.
Chart of Novastar Financial - Daily
The subprime meltdown spread to other areas of the financial sector and helped push financials and builders even lower for the week. The major investment banks like Merrill (MER), Lehman (LEH) and Bear Stearns (BSC) all took hits because they were either underwriters of billions in subprime debt offerings or own the paper outright for their own accounts. Lehman lost 4.2%, Merrill 4%, and Bear 3.4% for the week. This impact to the financial sector from this story is far from over.
In the housing sector the major builders were hammered on fears the evolving credit crunch would put more existing homes on the market and slow new home sales even further. Ryland (RYL) lost 7.2% for the week, HOV 5.5%, CTX 5.3% and DHI 4.2% to name just a few. These losses came despite some mildly bullish news from Lowe's. Lowe's profits fell -12% but they did manage to beat the street but that was not the good news. CEO Robert Niblock said "sales trends have bottomed" and they expect sales to pickup again as 2007 continues. On Thursday Toll Brothers posted a -67% decline in profits due to write offs for land options. CEO Robert Toll said there were too many soft markets to claim an upturn had begun BUT many markets were accelerating out of the slump. He said they were already reaching 2006 sales highs in some areas and able to raise prices again because of strong demand. He stopped short of calling a bottom but he was clearly leading investors to that conclusion. Investors wanted to hear more positive news and knocked -$2 off the post announcement price of the stock when it did not appear.
The market malaise prevented even energy stocks from posting any material gains despite oil hitting nearly $62 intraday. Most energy stocks were in the green but only fractionally. A lot of it may have been disbelief and the mix of a dozen external events confusing the issue. We had several futures contracts expire with natural gas going off the board on Monday. There were plenty of expiration pressures pushing prices higher. There were refinery problems at seven different refineries with the Texas Valero plant still offline and no target date to restart. A month delay would take 3 mb of gasoline and 1.5 mb of distillates off the market. There were more attacks in Nigeria and no letup in sight. Venezuela said it was diverting 8% of the oil previously headed to the US to China as Chavez continued his anti US program. Mexico said last week the Canatrell field, the third largest field in the world, was in catastrophic decline and could deplete completely in 5-7 years. That is a major blow to future production projections.
April Crude Oil Chart - Daily
Iran thumbed its nose at the UN and pledged to continue developing nuclear technology and enriching uranium. The IAEA report to the UN Security Council showed that Iran had escalated their pace of development rather than slowed it. Vice President Cheney put the prospect of a military strike against Iran back on the table during comments in Australia. After numerous comments from various administration officials that suggested there was no potential for attack the Iranian problem had shifted to the back burner. Friday's comments erased that position. He endorsed Senator John McCain's position that the only thing worse than a military confrontation with Iran would be a nuclear-armed Iran. Cheney said he had no doubt Iran was racing to enrich uranium to produce weapons rather than peaceful uses. Possessing nuclear weapons would give Iran complete dominance among the Arab oil producing states in the region. Cheney accused President Mahmoud Ahmadinejad of espousing an "apocalyptic philosophy" and making "threatening noises about Israel, the US and others." Cheney asked where was the point of no return? "Is it when they posses weapons or does it come sooner, when they have mastered the technology but perhaps not yet produced fissile material for weapons?" Oil hit its highs on the Cheney comments. Condoleeza Rice also pointed the spotlight on a possible Iranian confrontation saying Iran posed a growing missile threat and could not be allowed to cap those missiles with nukes.
Microsoft lost ground after announcing they would have to pay a damages of $1.5 billion for supposedly violating patents owned by Alcatel-Lucent. Reportedly Microsoft and hundreds of others paid a license fee many years ago to license digital music technology from one of the developers, Fraunhofer. Bell Labs, as part of AT&T, helped develop the technology. That company was eventually merged into Lucent and Lucent merged with Alcatel. Since the Alcatel acquisition the company has been on the warpath suing everyone who might have used the technology never claimed by Bell Labs. Dolby Labs fearing a suit on these grounds filed their own suit asking a judge to rule that its digital compression technology did not violate Alcatel's patent. They won and that case was upheld on appeal. Their case was a little different. Microsoft used the technology in its Windows Media product and obviously has deeper pockets than Dolby making them a bigger target. Alcatel sued Microsoft claiming every conceivable violation hoping something would stick. Friday's verdict will be appealed but that won't stop Alcatel from filing suit on other big names like Apple in an attempt to milk the Lucent acquisition for all it is worth. Bell Labs was awarded a patent for technology known as MPEG-2 AAC or Motion Picture Expert Group, Level 2 Advanced Audio Coding. The MP3 format licensed by Microsoft and others from Fraunhofer was MPEG-3, which stands for Motion Picture Expert Group Level 3 or MP3. This is the primary technology used to compress, encode and play digital music. You would think MPEG level 3 would be a later and more encompassing patent than MPEG-2 but Alcatel still claims their patent was abused. Further complicating the problem is a man named James Johnston, a former audio engineer and speech processing researcher at Bell Labs. He currently works at Microsoft and that was clearly pointed out by the offense at the Microsoft trial. Tough to assume he did not bring any of his digital compression knowledge with him from Bell Labs.
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After the bell on Friday news broke that buyout firm KKR was targeting Texas Utilities (TXU) with what could be a $40 billion buyout. The stock surged +$10 in after hours trading. The chart shows a sudden spike in buying interest starting intraday on Wednesday and producing a +$4 gain in just two days ahead of the news. Obviously the news leaked early and somebody made a lot of money. Word to whoever it was; the next time the phone rings it will be the SEC wanting to talk to you. TXU had a market cap at the close of $32 billion, debt of $12.3 billion and an enterprise value of $39 billion. If the deal is announced with a premium it could push the value over $40 billion making it the largest buyout ever. TXU has riled some people in Texas with their plans to build 11 new coal fired power plants costing over $1 billion each. The green community is up in arms but TXU claims it is the only way to get the cheap power needed to cope with the rapid growth rate in Texas.
BEA Systems lost -10% on Friday after giving investors cautious guidance. UBS cut its rating to neutral and Jeffries kept its buy rating but lowered their price target to $15 with the stock at $11.88 at Friday's close. BEAS did not report earnings due to its ongoing stock option review.
KLAC bounced +1.91 after saying they were going to buy back 10 million shares for $750 million. This is in addition to its currently unfinished 10 million share program announced in Feb-2005. If it takes them that long to buy 10 million shares then it could take years before the impact of the second program is felt. Sounds like an attempt to manage the price to me. If it works for KLAC them maybe it would work for us. That must have been the thought at Lam Research (LRCX), which announced a $750 million share repurchase of its own on Friday. LRCX has only repurchased $609 million of the prior two programs for $750 million. Why don't they finish the first program before announcing the second? Maybe they were trying to slow the two-month slide in stock price.
April Gold Futures Chart - Daily
Commodities were hot again this week with continued growth being reported from around the globe. Gold soared to an 8-month high over $686 on inflation concerns and the rising concerns over Iran. Speculative long positions in gold futures have risen to their highest level since the spring of 2006. Copper rose +7.4% and could be the clearest representation of global growth. Rio Tinto (RTP) spiked +$5 on Friday and +$12 from Wednesday's low. BHP broke out to a new 9 month high at $46. Gasoline surged +7% on the expiration of the March RBOB futures contract but also on the chance that past cycles would repeat. Late February is typically a low for gasoline futures as anticipation of the summer driving season begins.
Next week we get earnings from Dell Computer on Thursday and a look into whatever plans Michael Dell has now that he is back in the drivers seat. Vacation is over Michael, time to put on the armor and defend against Hewlett Packard. It is also retail earnings week with stocks like Target (TGT) and Nordstrom (JWN) reporting. With most of the retailers at historic highs and oil prices rising again we could see some disappointments next week either in earnings or guidance. I would not go so far as to recommend holding puts over earnings but I would not hesitate to jump in right after they report. There is a lot of profit at risk in some of those names and a couple of disappointments could sour the entire sector. The Retail Holders (RTH) could also be an option. With the switch to the summer blend of gasoline the price per gallon should rise sharply over the next month and that could put consumers back on the defense when it comes to discretionary spending.
The Dow set a new historic high on Tuesday and then fell for the rest of the week. It was far from a rout and more a lack of buyers than a sell off. With Friday's drop it returned nearly to its 30-day average at 12616 and a support level that has held every dip since August 2006. Eventually that average will be broken but until it does the game plan for most traders will be to buy any dip to that level. The -117 point loss for the week may have been the biggest weekly point loss since August but as I said earlier it is a meaningless statistic despite how much the press repeats it. The statistic we need to watch is the support at the 30-day average. As long as that level holds the rally will continue. BUT, don't forget we have several high profile economic reports midweek and a smoldering fire in the financial sector. For the bulls this may be just another wall of worry to climb but eventually we will find the straw that breaks their back. I heard several analysts suggesting we could have a -200 point Dow decline next week and that is entirely possible. That would be approximately 12450 and decent support. It would also classify as a -2.6% drop and break the pullback curse. As of Friday it has been 152 trading days without a Dow pullback of at least 2%. This would be a signal that all is clear and real buying could begin. Unfortunately we never know when that -10% correction will appear that starts with a harmless -2% drop. It has been 995 trading days without a 10% Dow correction and the 4th longest bull run since 1900. These numbers came from Ned Davis Research. I believe quite a few people would buy any initial 2% drop so any larger correction would not be straight down. For next week I would buy any further dip to the 30-day at about 12600. If that fails I would target 12450 for the next long entry.
The Nasdaq is far more bullish than the Dow with a new multiyear high set on Thursday and only minimal retracement on Friday. There are only a few financials and almost no homebuilders on the Nasdaq. Tech stocks are still in favor despite an almost daily dose of bad news from the chip sector. The Nasdaq has been respecting the 50-day average rather than the 30-day and that average is at 2457 today. A return to that support level would be healthy and would surely be met with a surge of buying. Dell reports on Thursday but I can't imagine anything they could say that could hurt the market. Everyone already knows Dell has lost the lead and is struggling. They may get a lot of press but I doubt they will be a market mover unless they really stink up the place. We could get some Vista acceptance numbers from Dell and that would be interesting.
The S&P is causing me the most worry. For seven days it struggled to get over 1450 and for the last seven it has struggled to remain over 1450. With the Nasdaq making new highs the S&P is barely holding its ground. Of course it is still better than the Dow but we know the Dow is not representative because it is only 30 stocks. The S&P has not returned to the 50-day average since August although there were several close calls. That average is currently 1430 and if you remember that was a key direction level for us for quite a while. A return to that level now would be a buy signal for me. That also suggests a break of 1450 should be a sell signal and I think that is also a decent trade.
S&P-500 Chart - Daily
S&P-500 Chart - 30 min
Russell-2000 Chart - Daily
The most bullish sentiment index is still the Russell-2000, which hit a new high on Thursday at 830 and only gave back 4 points into Friday's close. The small caps are still being bought and that means fund managers are still betting on further gains ahead. On the Russell initial support is 820 followed by 810. I believe each level will be bought in volume as long as nothing breaks on the news front to disrupt the current sentiment. Blunting this sentiment slightly is the stall on the NYSE Composite index. Resistance at 9450 has been solid and it will probably take some strong external event to produce a breakout. My crystal ball is not picking up any of those events on the horizon. However, that range bound rectangular pattern "normally" resolves in the direction of the prior trend. It is a consolidation pattern where opposing forces are balanced and waiting for the next move to occur. When it does occur it is usually on strong volume. A breakout here at the historic highs would be very bullish while a breakdown would not be catastrophic but simply profit taking with several levels of clear support to provide a rebound point at 9350 and 9250. A decline to those levels would just be normal profit taking in a longer term uptrend.
NYSE Composite Chart - 60 min
The most likely outcome for next week is a small decline. Nothing serious and it
be just another dip that will be bought. I would watch for complications
from the economic calendar and for any sign of a growing contagion from the
subprime mortgage sector. If news ever breaks that a major bank is at risk
because of the paper they bought or guaranteed then it could be lights out for
the rally. However, until an event like that occurs I believe the trend will
continue higher with any dips being buying opportunities. Watch the Russell for
weakness as a leading indicator
of fund manager sentiment.
Celgene - CELG - close: 56.28 change: +1.41 stop: 53.85
Why We Like It:
BUY CALL APR 55.00 LQH-DK open interest=15709 current ask $3.80
Picked on February 25 at $ 56.28
Ryder Sys. - R - close: 54.83 chg: +1.52 stop: 53.45
Why We Like It:
BUY CALL MAY 52.50 R-EX open interest= 176 current ask $4.40
Picked on February xx at $ xx.xx <-- see TRIGGER
Sealed Air - SEE - close: 66.82 chg: -0.32 stop: 64.84
Why We Like It:
BUY CALL APR 65.00 SEE-DM open interest=1038 current ask $3.20
Picked on February 25 at $ 66.82
Apache - APA - close: 70.47 chg: +0.07 stop: 67.95
Crude oil continued to rise on Friday but oil stocks pared their gains as oil slipped from its intraday highs. Shares of APA hit $71.37 Friday morning but gave back almost all of its gains. We would look for a dip or bounce in the $69-70 range as a new entry point. Our target is the $74.50-75.00 range. The P&F chart is much more bullish with a projected price target of $94.
BUY CALL APR 65.00 APA-DM open interest=3121 current ask $6.70
Picked on February 22 at $ 70.40
Boeing - BA - close: 90.28 change: -0.30 stop: 87.99
BA spent the last week consolidating sideways. This isn't too surprising since the DJIA peaked on Tuesday and sank the rest of the week. Overall the trend remains the same for BA. Shares look poised to breakout over resistance near $92.00 and the Point & Figure chart continues to look bullish with a triple-top breakout buy signal and a $107 target. We are sticking to our plan and suggesting a trigger to buy calls at $92.51. If triggered our target is the $99.50-100.00 range. More aggressive traders may want to jump in early on a bounce near $90 or a move over $92.00.
BUY CALL APR 85.00 BA-DQ open interest= 9 current ask $6.90
Picked on February xx at $ xx.xx <-- see TRIGGER
Diageo - DEO - close: 82.06 change: +0.64 stop: 78.45
DEO displayed some relative strength on Friday. Shares posted a 0.79% gain on relatively strong volume. Overall the trend remains bullish given the breakout over resistance near $80 a couple of weeks ago. We were expecting a stronger pull back toward the 10-dma or the $80 level, which could still happen if the markets see more profit taking next week. Our short-term target is the $84.75-85.00 range although more aggressive traders may want to aim higher. FYI: The P&F chart points to an $89 target.
Picked on February 14 at $ 81.04
Freeport McMoran - FCX - cls: 59.91 chg: +0.35 stop: 55.85
Gold and copper futures turned in some impressive gains this last week. That lifted the mining sector and shares of FCX broke out over resistance near $59.00. We were triggered at $59.25. Readers can choose to buy calls now or wait for a potential dip into the $59.00-58.00 region. Our target is the $64.00-65.00 range. Thursday's rally produced a new triple-top breakout buy signal on the P&F chart with a $75 target.
BUY CALL APR 55.00 FCX-DK open interest= 232 current ask $6.70
Picked on February 22 at $ 59.25
Chinese iShares - FXI - close: 105.40 chg: -2.60 stop: 103.99
The FXI suddenly and unexpectedly hit some profit taking on Friday. The ishares lost 2.4% without any clear catalyst. Chinese markets were down on Friday but they were down fractionally after trading near new highs. FXI's sell-off pulled the ETF toward technical support at the 50-dma, where bulls have bought the dip several times in the past. Monday will be an important test to see if traders buy the dip again. We would wait for a new rebound over $106.50 before considering new positions. Our target is the $114.00-115.00 range.
Picked on February 18 at $106.90
Research In Motion - RIMM - cls: 140.00 chg: -0.30 stop: 132.39
The upward momentum in RIMM stalled a bit with a minor pull back on Thursday and Friday last week. Overall shares look poised to move higher but the stock is facing potential resistance in the $142.50-145.00 region. If the NASDAQ or tech stocks in general see any profit taking this week then RIMM could easily dip toward $137-135. More conservative traders might want to consider tightening their stop losses toward $135. We would wait for some sign of strength before considering new call positions. Our target is the $149.00-150.00 range. The P&F chart has reversed into a buy signal and points to a $188 target (last week the target was $176). FYI: RIMM can be a volatile stock. The options tend to be expensive. We consider this an aggressive, higher-risk play.
Picked on February 20 at $140.51
Rio Tinto - RTP - cls: 230.37 chg: +4.79 stop: 216.99 *new*
Gold and copper futures surged higher this past week and the commodity strength fueled a rally in the miners. Shares of RTP bounced sharply from Wednesday's lows as traders bought the dip near its 10-dma. The stock is now challenging the November 2006 highs around $230. Overall the trend looks bullish but more conservative traders might want to consider locking in some profits given the $9 move from our picked price. We warned readers that RTP could find resistance near $230 and that traders should probably expect a pull back on the initial test. A pull back into the $224-225 region might be a new entry point. Our target is the $237.50-240.00 range. The P&F chart has produced a double-top breakout buy signal with a $298 target. FYI: RTP is a high-dollar stock and is bound to see some bigger swings (volatility) and this makes the options somewhat "expensive". Consider this a more aggressive play. Please note that we're adjusting the stop loss to $216.99.
Picked on February 14 at $221.15
Sears Holding - SHLD - cls: 187.65 chg: -2.32 stop: 179.89
After a strong week shares of SHLD hit some profit taking on Friday and shares lost 1.2%. We warned readers to expect some resistance and profit taking after the stock traded near $190. Right now we're expecting a pull back toward the 10-dma near $185.75 or deeper near $185. Next week the retail sector could see some volatility with several high-profile retailers reporting earnings. More conservative traders might want to exit early to avoid any sell-offs sparked by negative earnings news in the sector. We hesitate to suggest new positions at this time but a bounce from the 10-dma or the $185 level could be a new entry point. Our target is the $195.00-200.00 range. The Point & Figure chart is bullish with a $234 target.
Picked on February 14 at $183.64
MarineMax - HZO - close: 23.07 change: -0.01 stop: 24.25
The overall trend in HZO continues to look bearish but shares are not moving very fast and the lack of movement over the last two weeks is not good if you are holding options. We are not suggesting new positions although a drop under $22.00 would look like a new entry point to buy puts. More conservative traders might want to exit early or tighten their stops toward $24.00 or $23.75 to reduce their risk. The P&F chart continues to point to a $2.00 target. Our target is the $20.25-20.00 range.
Picked on February 11 at $ 22.59
Meritage - MTH - close: 40.81 change: -0.96 stop: 44.15 *new*
Homebuilders continued to sell-off on Friday. The DJUSHB index lost 1.9%. Shares of MTH slipped 2.3% and broke down to a new relative low. Bulls bought the initial dip near the $40 level but the bounce was struggling by lunchtime. We would not be surprised to see another bounce attempt next week but watch for it to fail in the $42.00-43.00 range. We are adjusting our stop loss to $44.15, since the $44.00 level held as overhead resistance last week. The P&F chart has produced a triple-breakdown sell signal with a $35.00 target. We are aiming for the $37.50-37.00 range.
Picked on February 11 at $ 41.99
Allegheny Tech - ATI - cls: 107.81 change: +1.33 stop: 102.49
Target achieved. Investors responded positively to news that ATI was raising its capital spending and plans to expand its titanium sponge production. The stock surged out of the gate on Friday morning and hit an intraday high of $110 before paring its gains. Our target was the $109.00-110.00 range.
on February 18 at $102.59
OM Group - OMG - close: 53.11 change: -0.06 stop: 49.75
We are suggesting an early exit in OMG. The stock is up over five points from where we suggested it and we'd hate to see it all evaporate if the broader market continues lower. Overall the trend in OMG is still bullish. Nimble traders might want to consider new bullish positions on a dip or bounce near $52.00 or even the $51.00 level but we'd try and play with a tight stop loss on any new positions. If you do open new plays you'll need to adjust your target. Currently the P&F chart points at a $72 target but we see potential resistance at $55 and near $60. We had been aiming for the $54-55 range but we are happy to exit early right here.
Picked on January 25 at $ 48.05
Lots of traders have a dirty little secret. They don't truly understand how order execution works. It's not too difficult to set up an online order and click "send," but what happens to the order you've sent? What's "internalization" or "payment for order flow"?
The SEC wants to help. Believe it or not, a government site has a clear and simple explanation of order execution, complete with a graphic describing the various steps. The explanation and graphics can be found at http://www.sec.gov/investor/pubs/tradexec.htm
Because the site explains the basics of order execution, I won't go into a complete discussion here, but what about those terms I asked about in the opening paragraph?
Your broker sometimes internalizes your orders. This happens when the broker routes your order to a division of the broker's firm. That division then fills your order out of its own inventory. Your order never makes it past your own brokerage, and that brokerage has the opportunity to make money on the spread.
Some brokerages send your orders to a regional exchange or to what is known as a "third market maker," a firm that agrees to buy or sell a stock at the publicly quoted prices. These regional exchanges and third market makers want your brokerage's business, so they may pay your brokerage (not your individual broker) for routing your orders to them.
There's been some controversy about payment for order flow. Some traders don't like the idea of using brokerages that pay for order flow, feeling as if they're not getting the best prices despite the requirement that they get the publicly quoted price. Some researchers believe that, although there's some variability among those companies providing order flow, some firms provide superior execution to the execution that traders might receive on an exchange such as the NYSE. Obviously, some may not.
The brokerages obviously like the tactic. They like it for reasons other than the rebate they receive for each order although those are an important source of income for some brokerages. Routing their orders this way is equivalent to a small company hiring a firm to administer their payrolls, withholdings, employee insurance and other such matters. It allows small firms to compete with larger ones because they've been able to economize. They don't have to set up and maintain the infrastructure they would need to be able to execute a large number of orders each day. For this reason, if you ask your brokerage to route your order to a certain exchange, supposing that your brokerage allows such requests, your brokerage may ask you to pay a bit more in commissions.
It may be difficult for individual traders to sort out whether they benefit more from having a brokerage that doesn't accept payment for order flow or from one that does. Your broker does have the obligation to get you the best execution that it's able to receive, whether that's through an exchange, a market maker, an ECN or electronic communications network or through internalization.
However, even if your brokerage is doing all it can to obtain that best execution, doing so requires that the brokerage make some decisions. Is it best to send the order to a particular market maker where it might get a better price or, in the time it takes for the order to be transmitted, might that better price be gone?
Some brokerages are certainly better than others at getting you that best execution, either because of the brokerage's internalization and payment-for-order-flow practices or because of the decision-making process mentioned in the previous paragraph. You can check out some of this information. The SEC requires that all brokerages tell their customers the names of the market centers to which they send a significant number of their orders, asking that this material be gathered once a quarter. If you have questions, you can also request that your brokerage reveal where your individual orders were routed. They're required to provide this information for orders executed in the previous six months.
The market centers to which your orders might be routed are also required to make disclosures, and they're required to do it monthly and in detail. How do they handle market orders of various sizes? When customers send in limit orders, how are they doing with providing executions at prices that are better than the public quotes?
If you're not satisfied with your broker's record or the way your individual orders are being handled, you can contact prospective new brokers and ask them how order flow and internalization are handled in their firm. You can compare notes, but I wouldn't take their word alone. Take a look at the new account agreement for each brokerage you're considering.
The SEC has some other ideas for checking out brokerages, including a check of your brokerage through the www.nasd.com site, where you'll find information under "Investor Information," then "Investor Protection," and then "Check the Background of Your Investment Professional."
In addition to the other information, you'll find out if your broker has had any
run-in's with the
legal system. Let's hope that this discussion of some traders'
dirty little secret, their lack of knowledge of how trades are executed, doesn't
lead to a discovery that any of our subscribers' brokerages have dirty little
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
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