It is probably a good idea for an investor to have a working knowledge of how stock and option orders are actually executed, as well as the history and trends of that process. This knowledge should save the investor money in the long run, along with the increased ability to both select a broker and judge the quality of execution services received. It may also serve to help judge the quality of pundits speaking on the subject. In this article we will discuss briefly the history of the major stock exchanges, as a backdrop to the major changes incorporated in the formation of the Chicago Board Options Exchange in 1973 and subsequent changes of payment for order flow and off exchange trading.

Historically stock has been traded either on a specific exchange, such as the New York Stock Exchange (NYSE) or American Stock Exchange (AMEX), or on the over-the-counter market, or NASDAQ system. Let's talk about the exchange system in part one.

Under this system companies actually make application and pay fees to have their stock "listed" and traded on a national exchange such as the NYSE. They do this for various reasons, such as the prestige of the institution, the belief that the exchange's trading system will provide solid liquidity for the trade in their stock, long-term history of relatively few trading interruptions, etc. There are also minimum listing standards for companies making application to the various exchanges.

The system of trade used on both the NYSE and AMEX is known as the specialist system. Under this system a listing, or stock, is essentially assigned to a member or member group known as a specialist who is charged with the responsibility of providing a fair and orderly market for the stock. Among other responsibilities the specialist is required to provide a two-sided market in the stock, meaning there is continually a price at which the specialist will buy the stock from an investor and a price at which the specialist will sell that stock to an investor. The difference between that buy price and sell price is known as the spread. For instance, IBM would traditionally be quoted $120 1/8 bid, $120 3/8 ask, meaning the specialist, or possibly another public customer, is willing to buy some amount of IBM stock at $120 1/8, and is willing to sell some at $120 3/8. The tape records the price and amount of the last trade that occurred in the stock, but the important numbers for the next trade are the current bid and ask.

Isn't America great? Where else could we find people so philanthropic that they are willing to sell stock to people when it is going up, and buy it from them on those days when it is going down? Fortunately for those of you worried about the specialists being disadvantaged, the exchange has seen fit to give them a few huge advantages. First, let us not dismiss the advantage of trading on the bid-ask spread. At the then minimum spread width of $ 1/8, and usually wider, there is a lot of money to be made at those times when the stock is stagnant, and the paper is what we call two-sided. That means that there is a rough balance between investors selling and investors buying, meaning the specialist is continually buying at $120 1/8 and selling at $120 3/8. That's $250 profit on every 1000 shares bought and sold.

Second, the specialist is able to represent orders and receive commission dollars. These fees have come down dramatically in recent years, but still remain a huge source of income. One key point here, and one we will keep coming back to in future articles, is the combination of the agency and principal function. The specialist can charge for representing an order, then trade against the order himself. Some cynics like myself feel there is virtually always a conflict in this dual role, if it is such a good buy, why are you selling it to me? The third huge advantage the specialist has is the maintenance of the customer order book. In the above IBM example there may be literally hundreds of standing orders the specialist is aware of "sitting" on his book. For instance, many investors are probably willing to sell above the market, and there may be many shares offered at $122, some at $122 ½, etc. It certainly makes it easier to sell 2,000 shares at $120 3/8 if you have 10,000 offered in the book at $120 1/2. It is also the reason why in a rising market the specialist can get and stay long even though he is selling to most incoming customer paper.

There used to be competing specialists on the NYSE way back in history, where more than one member or group would compete via spread width for the orders. However, that practice was stopped long ago, and one person essentially has the franchise for each stock, franchises that are worth huge money.