Reading the Specialist.

Discussion in 'Order Execution' started by rtharp, Dec 17, 2001.

  1. reading specialist.

    This topic was brought up on another thread and is getting off topic. So I'm starting a new thread. I'm tired right now but will add more later

    such as a few links and such
    Robert Tharp
  2. DeeMan


    Thought I would start things off by sharing some of the things I have learned through my own experiences, and how it might apply to daytrading the NYSE. This is intended to give a little insight to some of the newer traders who are having a hard time finding information on reading the tape/specialist. I would welcome any of the more experienced traders to correct my mistakes or fill in things that I have missed. In a previous thread I spoke a little about how generally an institutional order works on the floor ( - hope I did that right). I think it's important to understand the big picture in order to profit from scalping, so let's start from the beginning…

    What moves a stock price up and down? Easy - supply and demand. We all know that, and if we could just figure out when one was higher than the other, we would be successful traders. So where does this supply and demand come from? It comes from many different sources, but by far the most significant are the institutions. If you are a new trader do not be discouraged by some poster who quotes something like 'Yeah, I love taking some newbie's money'. That person clearly does not understand the mechanisms of the overall market. Whenever you buy or sell any stock, chances are there was an institution on the other side of that trade, not another daytrader. But don't worry about that - institutions come in all shapes and sizes, and are as wrong as often as we are. So in order to make money, we need to figure out when a good size institutional order is out there buying or selling. We have two tools to figure this out: The tape (which shows us the past - what has traded) and the specialist (who shows us the present - what the changing current market is). Which is more important? In my opinion it's the tape. The tape doesn't lie. Specialists can. But don't discount the specialist; he's going to determine your entry and exit points.
  3. DeeMan


    I. Think Like an Institution

    Like everything else in life, we tend to see things in our own image, and we try to explain things by using our own motivations. Trading as if everyone out there was a daytrader can be a costly mistake. If the market is an ocean, being tiny little fish, we are better off feeding off the scraps of larger fish than going head to head with other tiny fish. So what is the motivation of the institution? Obviously to make money, but not like us. An institution is not buying 1,000,000 shares of ANN to sell it back .25 cents higher. Most of their buy/sell decisions are based on fundamental analysis. Nowadays there are quite a few hedge funds that I know of that base everything on technical analysis, but even they are looking for a few points gain at least. The point is this: How many times have you bought a stock after spotting a significant buyer, saw a little resistance and subsequently sold for a 25 cent profit, and then watched the stock go up another dollar or more throughout the day? It can be very frustrating. What you need to understand is that what is important to you may not be important to the institutional trader. Yes, you care about that 10 cents. On 1,000 shares that's $100. But to the institutional trader who needs to buy those 1,000,000 shares it does not matter. What? That's $100,000! Well not really - could I really buy 1,000,000 shares at one price? No, not unless I negotiated upstairs (read the other thread). But what if I could buy 10,000 ANN at $31.50, 25,000 at $31.70, or 50,000 at $32? What would I choose? If I had 1,000,000 shares to buy I would easily choose 50,000 at $32. Why? Because of the most important aspect of institutional trading: opportunity costs. By saving a few pennies but having less shares I have just cost the firm money (and thus the clients), if the anticipated result occurs. It is more important for the institutional trader to complete the order than to get the best price. Sounds incredible but it's true. Remember, with the exception of some hedge funds, money managers make their money from management fees and commissions, not performance. True, if your performance is really bad, you may lose some clients, but from what I've seen, just plain bad performance interestingly enough doesn't seem to have any harsh consequences.

  4. DeeMan


    There is a poster here whose signature reads "Trade what you see, not what you think." That is my favorite quote. Did you ever see a perfect setup - the market is up, the sector is up, the tick is positive and even a ray of sunlight is shining on your enter key to transmit your buy order, only to watch the stock continuously drop from unrelenting pressure? Somebody must know something, right? Let me tell you a little story. One morning I went into the morning meeting as usual, where the futures were up strong and one important stock had beat the street with good numbers. One of our holdings was a much smaller company but in the same sector as the larger stock was. One of my bosses had called the CEO to discuss the ramifications of the day's news, only to be treated "rudely" by the secretary. One hour later I had instructions to sell all of our 1.2 million shares. By the end of the day the sector index was up 4%, the stock was down $2 (about 7%). Only now can I feel the pain of the poor daytrader who just couldn't understand why. Why is not important. I have many stories similar to the one above. If you only knew some of the reasons of why I have bought/sold tons of stock you would be in shock. If any of you watch Seinfeld, then just picture the character of George Steinbrenner running an investment firm. (Big Stein wants his calzone!) It was certainly an interesting period of my life…

    What's my point? When there is heavy buying pressure you should be buying, and when there's heavy selling you should be selling. In my last firm, we managed about $2.2 billion in equity. On average, I would trade about 1.5 ~ 2 million shares of stock per day. There are tens of thousands of other institutions out there that are much bigger than that buying and selling all day long for a number of reasons that may never have occurred to you. I never once looked at a chart and said 'Hey, ANN is at its 50 day moving average, I think I'll stop buying it'. My head would be on display on the trading desk as a warning for all those who dare to go against Big Stein. I can honestly say that most days I went home not knowing whether the market closed up or down. It was never a factor. It only mattered on extreme days - i.e. if the Dow is down 200+ there's no need to step up on any buy orders. Actually it's very common. As a test we used to call the other traders on the street through the direct lines and say 'Quick - what's the market doing?' Almost always there was a long pause with the occasional ummmmm, and after they looked at their monitor we would get an answer. The most important numbers for an institutional trader are the high and low of the stock, and round dollar prices ($32, $33, etc) which act as "mental" barriers of support/resistance. As much as I love and believe in technical analysis it is important to see it for what it is; a tool to measure investor/trader sentiment. Over the long haul it probably works pretty well, but it can never know the urgency of today's institutional buyer/seller. For that information we only have the specialist and the tape.
    VPhantom likes this.
  5. DeeMan


    II. The Specialist

    What is the Specialist's motivation? Most of us see the Specialist as some evil guy who's sitting on a 10,000 share sell order, just waiting for us to buy a few hundred shares so he can fill us and immediately knock the stock down half a point. While it can feel like that at times, his primary goal is not to screw us. His primary goal is to maintain a fair and orderly market. That's his job. In doing so, if he happens to make money, all the better for him. In order to keep the market as fair as possible, the Specialist will work harder for the large institutional orders, for a few reasons. First, because the large orders dictate in which direction the stock will move. Next, because of the relationships on the floor. If I'm going to sell 1,000,000 shares of ANN, it's going to take me a few days, and I'm going to be on the phone with my floor broker who in turn will be dealing with the specialist during that time. Is the Specialist going to screw me on 5,000 shares just to make a few pennies, risking a bad relationship with the guys on the floor who have to tell their client the bad news? (Actually, some have done that before, but it's not the norm) As discussed in that older thread, the Specialist will always want to know from the floor broker if there's more stock behind it. The more he knows, the more he can act accordingly, and the more he can profit from it. He realizes that the institution does have power in the form of size. If he has 5,000 shares left of a 25,000 share sell order from me, and he prints the 5,000 down an inexcusable amount and buys the stock from me just to try to make a buck, I can stuff a few hundred thousand shares in the form of a market order (where he cannot get out of his position) down his throat and he will lose money. In the long run that type of behavior won't benefit the Specialist.

    The Specialist makes money in two ways: when traders buy and sell the spread that he has created for the stock, and by buying and selling out of his own inventory when certain situations occur where he is almost certain that he will make money. Playing the spread is easy. The Specialist can trade in front of a limit order, so he can basically adjust his spread all day. He'll normally do this when there is little activity in the stock (like the Dead Zone) and an absence of institutional buyers/sellers.

    The other way the Specialist makes money is by buying or selling the stock at specific times in order to profit from moves; much like us, but with a lot more certainty. This is an example of when a little knowledge can be dangerous. Once people learn this they start to assume that the Specialist was part of every decent size print that trades. Next they assume that the Specialist is a participant of every opening trade. This is simply not true. The Specialist is not a risk taker. He doesn't have to be. If the opening of the stock is uneventful, there is no need to participate. He does not know in which direction the market is going to go, so why take the risk? It is only on those special circumstances, where some form of news will affect the stock, when there will be a gap up or gap down, that the Specialist might be involved. And even then, there is no guarantee that the Specialist bought stock on that gap down. Remember, a Specialist sees all the order flow on that stock that morning, which includes cancelled sell orders because the price is getting too low, and cancelled buy orders when the opening price looks to be too high. We only see the opening price after the delayed opening on a large print. We don't know how many institutions "checked" him. Floor brokers will be constantly checking the Specialist and changing their orders and reporting back to their clients with the opening indications, which eventually are displayed on a news server (unfortunately delayed and usually inaccurate). The Specialist gets a good sense of where buyers might come in and where sellers will start to unload and is pretty sure of whether he will be able to profit from it or not.

  6. DeeMan


    One final note on openings - when an institution is buying or selling a stock the trader does not give the whole order to the Specialist on the opening. If I had to sell 300,000 shares of ANN, I would only give 25,000 - 50,000 shares depending on how big the opening print was going to be, just to test the water. Then I would see which way the stock was trending, and act accordingly. Nobody is going to show his hand, and it is very rare for an institution to buy/sell their whole order on the opening print. The Specialist is very much aware of this fact, and that is why he is not always a part of the larger prints that go up later in the day. If I continuously feed 25,000 shares of ANN to the Specialist without telling him my size, do you think he will take a chance and buy any significant amount of stock at any time during the day just because the stock is lower? No, he'll keep asking the floor broker who keeps giving him the order if there's more behind it. It could take days. But when the order is finished, most traders won't care about letting the specialist know, and now he'll participate on the clean up print.

    So how does this apply to "reading" the Specialist? It keeps the focus on what we really want to know: how the Specialist handles larger orders, not how the Specialist makes money for himself. The Specialist will always make money and unfortunately we can't use the same methods for ourselves. For those of you excited about the possibility of 'Open Book' on the NYSE forget it. Do you really think that an institution would give the Specialist a 200,000 share sell order if the whole world could see it? Or even 50,000 shares? No, the orders will just get smaller that's all.

    So actually we're not looking for much, just a typical pattern that the Specialist continues to exhibit when working a large order. Lets say the Specialist in ANN receives an order to buy 50,000 shares at the market, and he doesn't have a natural seller. What is his normal process? Well, if you knew beforehand that he had this order, and then watched what happened it would be easier to see, but unfortunately you'll have to work backwards and try to figure things out which will certainly take much more time. How does he start? Usually he'll start by flashing a decent bid of about 5,000 shares. It's a strong bid, but not enough to scare anyone away. If he gets some nibbles, he might up the ante and show 10,000 shares. As a daytrader, we get excited when we see this, but we need to think like an institution. If I was an institutional seller of ANN, I'd be more likely to react to a real bid than a tiny bid. That's what the Specialist is looking for. But if he can't lure one in, he'll have to just pick away, which means buying at the offers (Not many small orders will feel the need to sell 500 shares into such a strong bid). So the stock moves up slightly as different offers are taken, but how does the Specialist handle this? If he's accumulated 5,000 shares already does he sit tight with a 5,000 share bid at the original level? Does he replace with bid with a higher 2,000 share bid? Does he remove the bid altogether to make it seem like there's no support? You may have been watching the stock for the last hour, but will every trader catch that? Making the stock look weak is a common strategy. Instead of dropping the bid, it's actually more effective sometimes to show a weak bid, of say one or two hundred shares, as well as a strong offer one cent above it making it look like the stock is ready to fall. Not a bad way to attract sellers. Does the Specialist in your stock do this? How many times? What happened when sellers took out the weak bid? Where was the next bid? Where was stock being printed? Was it 5 cents below the weak bid? 10 cents? Some specialists will use the same amount every time. And unless the stock has just run up a lot already, he won't let the stock fall too much - remember his primary goal is to fill the order, not to get too cute about it's execution. He's still got more stock to buy, so he'll take all those panic sell orders and execute them at the same price. Eventually if there's no supply, the stock will move up. Does the Specialist use another 5,000 share bid, but up higher? Kind of obvious, huh? How about 3,400 shares - looks more like a stray order. Another 10,000 shares accumulated, time for the old 'weak bid' trick again. You get the point. The key is watching, and I mean really paying attention to what is going on so that you can get a good idea of the behavior of the Specialist when he has a large buyer and no sellers (or vice-versa). This could take an extremely long time, but could be well worth the effort.

    One last thing - some Specialists trade more than one stock (not the really big ones), and at times, their attention may be drawn to another situation. Sometimes they are out sick or on vacation (or out to lunch). Sometimes an institutional trader will tell them exactly what they want them to do as far as showing bids/offers that may make no sense to us watching the stock. It happens, and there's nothing we can do to change that. Just try to stick with what usually happens, not what happened last.
  7. DeeMan


    III. Tape Reading

    Interpreting the tape can seem very difficult and overwhelming at times, but it gets a little easier with practice. The key is not trying to interpret every trade that is printed, but rather to look for and identify situations that indicate a large or aggressive buyer/seller. We don't need to know about the small orders that are being traded back and forth all day - they can occur for a variety of reasons (retail orders, etc.), none of which concern us. So, what are we looking for?

    Momentum. Is the stock moving up or down? If it's moving up I'll bet you that prints are going off at the offer. If it's going down then prints are going off at the bid price. That's the most basic and important rule of tape reading. How many times have you seen a bid get hit and then saw the bid step up to a higher level, only to get hit again, and then move to a higher level? Doesn't make much sense. When bids get tapped they go lower. In order to gauge momentum we need to look at the prints on the tape and the stock price, not the Specialist. What if the market in ANN is being shown as 10,000 bid at $31.60 and 1,000 offered at $31.70. Which way is the momentum? If nothing has traded then there is no momentum. However, if three trades of 1,000 shares each go off at $31.60, then the short-term momentum is down, even if the bid amount is greater than the offer amount. Is that enough information for us to make an informed decision of shorting the stock? Of course not, but it's a start. It's telling us that the sellers have a greater sense of urgency than the buyers at this time. I know this is really basic but it really is the key to profiting off stock momentum (NYSE or NASDAQ).

    Once you've got that down you're ready to look for some institutional buyers/sellers. The first and easiest thing to spot is big size on a bid, taking out offers and stepping up on the bid. That clearly represents an aggressive buyer, as well as a market order. You'll have to be quick though, because everyone else is seeing what you're seeing, and when the momentum starts to die down, and the bid is down to a few thousand shares, there will be a quick pull back. How much and how quick depends on how fast and severe the stock just moved up. Obviously this works on the downside as well, but to capitalize from it you'll need bullets because you probably won't get any upticks to enable you to get your short off.

    The next is when a large offer that has been sitting at one price for a while gets taken out (the larger the better). That shows that the buyers were willing to step up and pay the offer for size. It also breaks a mental "barrier" and buyers tend to feel there may not be any more supply left and scramble to buy whatever they can, and thus the stock moves up. Eventually it will get to another level where supply comes out and the process starts all over again. Since this technique is pretty much known buy everyone you may have to take more of a risk and wait until there are only a few thousand shares left on the offer and buy your stock. By jumping the gun, you risk the occurrence of the offer being refreshed by another large offer, but it guarantees that you won't miss any moves if the stock takes off. Again, this also works the same on the downside.

    Another thing to look for are the double prints (my favorite). I went into detail about this in that older post, so please see that thread I referred to on the first page. This can be a very useful tool. Two buyers of 10,000 shares each are stronger than one seller of 20,000 shares. The fear that another buyer is out there whose size and intent you don't know will definitely motivate you to buy your stock faster and with less care as to execution.

    The next thing to focus on are the larger prints. When a stock on the NYSE makes a move in a specific direction and is subsequently followed by a large print at the end of the move, it tends to signal a reversal (at least for the short term). Why? If I'm selling 100,000 shares of ANN and I knock the stock down 50 cents, while selling 35,000 shares, I'll be willing to sell the rest at a lower price if I can do it. Eventually the stock will find a level that will generate some buying interest. If I'm the buyer, then I'm in the driver's seat because I can produce a discount bid. If I'm the seller, I'm more likely to capitulate and sell the rest of my stock at one price. So if I can sell 65,000 down another 30 cents, I'll do it. But now my order is finished (for the moment at least - institutional traders tend to take a break after a significant piece trades to "let the dust settle") and the stock is at a level that has generated buying interest. The print goes up, the spread widens, and before you know it, the bids start stepping up for fear of missing a golden opportunity. If you're quick enough, you can profit from the short-term panic move. But what comes next is the most important. After the stock retraces a bit, if another large offer appears and does not get hit, this is where you cover your long and go short. The seller is back, and from the tape you know that he has sold at a lower price. He will have no problem doing it again. If this sounds new to you don't be impressed: you've seen it before. Where? On any intraday chart. The stock makes a decent move in one direction, retraces a bit, (you were taught to buy/sell at this point) and then continues in the original direction. It's the same thing, but now your info comes in the form of the tape instead of a chart.

  8. DeeMan


    One thing I want to add is to be careful on playing the first move when a large print occurs at the high of the stock. Yes it often works well enough, but not as well as on the downside. The reason is this: Buyers are stronger than sellers. A buyer can always walk away, whereas a seller cannot. That is why stocks go down faster and harder than they go up. That is why most negotiated large prints are executed at a discount and not a premium. Most buyers will not pay a premium on a large print if it is the end of their order. They will however pay up to get some stock under their belt (remember to think like an institution), in case the stock moves even higher. Once that "high" print goes off, the specialist will usually not let the price fall too much too soon to avoid embarrassing the buyer, and believe me, the buyer will be pissed if he tells his PM that he just bought 50,000 shares at $31.90 and a minute later the stock is at $31.50.

    One thing that can be read from the tape but is easier to see on an intraday chart is consolidation. On the tape there may be a battle between a buyer and a seller or there may be just inactivity. If you watch the tape during this time you will start to take notice of the key support and resistance levels. Eventually either the buyer or seller will finish the order, and there will be a lack of supply or demand. Key levels will be broken and that is your cue to go along for the ride. It may be boring to watch, but by watching the tape you may have a better chance of spotting real breakouts/breakdowns by looking at the size traded as opposed to the price where it traded (chart method).

    Another thing I have not mentioned yet is spotting market orders. Market orders are very important in getting a stock to move in a specific direction. A large limit order can give you support in case the stock doesn't move, but isn't going to help you in making money. So how can you tell? Well aside from the obvious large bid stepping up pattern, you can't know for sure. But when I used limits as an institutional trader, they were always significant price levels - $32, $31.75, $31.50, etc.. I wouldn't give an order to buy 25,000 ANN using a $31.46 top. So when you see larger bids/offers at an odd price, they probably have room.

    What else can you look for? What happens when you see a spread like this: 3,000 bid at $31.50 and 1,000 offered at $31.60, and a few prints of 1,000 shares go off at $31.59. Shouldn't they go off at $31.60? What just happened? It could be a couple of things. The first is that the Specialist jumped in front of a limit order to sell from his own inventory, because he knows that there is a large supply right above. Or, the Specialist could be working a large sell order with a lower limit (or a market order) but does not want the offer to be taken out. Or it could even be that a sell order of 3,000 shares came in with a limit of $31.59 at that exact moment (yeah, I know, but it could happen). Either way it doesn't matter why, because all of the reasons are bearish, not bullish. You've got buying momentum but too much supply, so if I was long stock, now is when I would pay very close attention to when the buying stops and the momentum reverses.

    When you start to trade larger sizes you will also be able to "test" the specialist. When supply runs out the Specialist will often try to keep a lid on the stock by offering a few hundred shares a few cents away from the bid. If you want to know if it's a real seller, you can buy just a hundred shares. If the ask changes from say 400 shares to 300 shares it's probably a real seller. But if it was the Specialist, you'll get your 100 shares at that price, but the rest of the offer will often just disappear. You can also try a different approach; you can join him at the offer with a hundred shares. If you see 400 shares offered at $31.80 and you enter an order to sell 100 shares at that price and the amount then shows 500, chances are it's a real seller. But if it's the Specialist, chances are it will show 500 shares for a split second, and then you'll be all alone with 100 shares offered at $31.80. Cancel it quickly and you might get a glimpse of the real market.

  9. DeeMan


    I really think the best way to practice reading the tape is to pick a small/mid cap stock that trades about 200,000 - 400,000 shares a day and watch it for a week. Yes, it will get boring, but keep a piece of paper in front of you and take notes. Not only should you paper trade, but also write down your concerns, ideas, and questions about the stock and the overall market and it's effect on the stock. Your questions will be answered later by watching how the stock trades. On the first day you'll probably want to buy every time the bid is bigger than the ask (and vice-versa) and by paying the spread you'll find that at the end of the day you would have lost money. When you start to get the hang of momentum, your shooting percentage will increase because you'll be able to better filter out the noise. Next start trading 100 shares because honestly, execution is everything when trading. Great ideas that would have worked don't pay the bills. The more size you trade, the harder it will be (% wise) to make money from scalping so I think it's important to prove yourself on 100 shares first.

    What I have just written is by no means some "secret" formula to instant wealth. It's just a simple guide of perhaps how to get started in the right direction, in case you're having trouble finding anyone willing to share any ideas on this topic. I am continuously learning everyday and am always eager to learn from anyone else who has any tips/techniques to offer me. Happy trading!

    jser likes this.
  10. The advent of the NYSE Open Book is gonna lead to more specialist games, akin to the Nasdaq games that we are all aware of... it will be interesting to see if classical NYSE tape reading will still be feasible, when the Open Book becomes generally available.
    #10     Dec 20, 2001