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Is 'Mid-Point' Pricing a Better Way?

July 13, 1999|WALTER HAMILTON

The best way for individual investors to avoid getting whipsawed at the Nasdaq market's opening is to use "limit" orders.

With a limit order, you specify that your trade should be done only at a specific price, or better. That contrasts with "market" orders, which are executed at the prevailing market price.

The risk of using a limit order, however, is that your order may not be filled.

Some Nasdaq dealers have another idea to improve opening prices for investors: so-called mid-point pricing, which splits the difference between the dealers' stated "bid," or buy, price and their "ask," or sell, price.

Two major Nasdaq market makers--Bernard L. Madoff Investment Securities and Knight/Trimark Group--have, to differing degrees, pledged to use mid-point pricing at the Nasdaq open.

How does it work? Rather than buy stock at the bid price and sell at the higher ask--and pocket the "spread"--Madoff is offering mid-point pricing at the open to the degree that it can match offsetting orders from customers.

Imagine Madoff has orders to buy 50,000 shares of WXYZ and offsetting orders to sell 50,000. If the best bid is $50 and the best ask is $50.25, the firm would match all orders at $50.13. Those customers would trade with one another instead of with the dealer.

If Madoff had an excess of buyers, it would price every trade at $50.25, thus at least helping sellers get a better price. With more sellers, all investors would receive $50, thus aiding buyers.

Knight/Trimark says it offers mid-point pricing at the open on up to 250,000 shares of any stock regardless of the ratio of buyers to sellers. When the number of buyers tops sellers, or vice versa, Knight/Trimark uses its own capital to take the other side.

Many observers say individuals benefit from mid-point pricing.

"That's unambiguously good for investors," said Dan Mathisson, head stock trader at D.E. Shaw Securities, a New York-based institutional trading firm.

Some critics, however, are unimpressed.

Bid-ask price spreads have narrowed since Nasdaq adopted new order-handling rules two years ago following investigations by the Justice Department and the Securities and Exchange Commission of price-fixing among Nasdaq dealers. So mid-point pricing is "not a big deal because spreads have narrowed so much," said John Wheeler, a senior equity trader at American Century mutual funds.

More important, Wheeler said, "Mid-point pricing doesn't affect at all [dealers'] ability to mark up and mark down the openings"--in other words, to influence the market so that prices overall are marked higher, or lower, to the benefit of dealers' inventories of shares.

"They act like they're doing a service, but they're making millions by doing this," Wheeler said.

Indeed, the more "order flow" a dealer attracts, the greater its potential profit on trades from its own inventory.

With Nasdaq planning next year to quote stock prices in decimals rather than fractions, prices are likely to move toward the mid-point anyway.

"We didn't do this for motherhood and apple pie. It's a competitive market," said Bernard Madoff, head of Madoff Investment Securities. "If stocks are going to trade that way eventually, then we might as well get there first."

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