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The Opening Bell May Not Be the Best 'Buy' Signal


Many online investors go through a ritual each morning.

They sign onto their broker's Web site to check the condition of the market and the prices of specific stocks.

And if they've placed a buy or sell order late the previous day or early that morning, they do something else as well. They read an e-mail from their broker telling them the price at which they bought or sold at that day's market "open."

With individuals placing a crush of orders each night after the market has closed, the start of trading each morning has gotten more frenzied as Wall Street firms scramble to process the orders. By some accounts, as much as 40% of online trades are submitted when the market is closed.

"It's become almost an event unto itself," said Michael Sanderson, chief executive of Eclipse Trading Inc., an after-hours trading firm.

But as the volume of opening trading has surged, so has criticism of the process in which stocks' market-opening prices are set, especially on Nasdaq.

"The opens are getting bigger and there's more and more volume pouring in, so you're getting wildly different fluctuating prices from the [previous day's] close," Sanderson said. "You have no idea what the price is going to be."

The presumed advantage of trading at the opening is that many other investors also are in the market at that point, creating significant "liquidity."

Yet some experts charge that small investors, in particular, often are saddled with inferior "fills"--and that they frequently end up buying at the day's high or selling at the day's low, to the benefit of Wall Street dealers.

Critics say that the New York Stock Exchange specialists and Nasdaq dealers are able to set opening prices that are advantageous to them.

For example, if individuals have put in a large number of buy orders overnight, the Street firms holding inventories of shares to sell have "an incentive to mark that price up at the open, sell all that stock and then get out of the way," said John Wheeler, a senior equity trader at American Century mutual funds.

While that is legal, it can be aggravating for small traders who may get whipsawed.

To see how all this works, it's important to understand the distinct ways the market opens each day on the NYSE and Nasdaq. Both exchanges are open between 9:30 a.m. and 4 p.m. Eastern time, but they trade stocks differently.

On the NYSE, a single "specialist" is responsible for handling the trading of each stock. The specialist determines each day's opening price, and once it's set, all buyers and sellers at the open receive it.

In the half-hour before trading begins, the specialist typically sends out "indications" to floor brokers who represent large investors. An indication is the price range at which a specialist is considering opening a stock.

Based on the indications, floor brokers tell the specialist what their orders would be at various prices. They might, for example, buy more shares at a lower price. The specialist considers that information and sets a final opening price.

On Nasdaq's "dealer" market, prices are set by market makers--the large Wall Street brokerages that stand ready to buy stock from, and sell it to, investors.

Each market maker sets a "bid" price at which the firm will buy a stock from an investor and a higher "ask" price at which the firm will sell it. The market maker typically earns the "spread" between the two prices. So the more volume there is, the greater the potential income generated by the spread.

"That's a big part of the market maker's profit during the day," said Bernard L. Madoff, head of Bernard L. Madoff Investment Securities, a Nasdaq market maker. "They make a lot of money on the spread at the open."

Online brokerages such as E-Trade Group or Ameritrade Holding normally rout their customers' Nasdaq orders to a handful of market makers that actually execute the orders, such as Knight/Trimark Group, Madoff Securities and Herzog Heine Geduld.

The highest bid--the highest price at which any firm would buy stock from an investor--and the lowest ask (the lowest price at which any firm would sell) is known as the "inside market."

Regardless of their own quotes, market makers are supposed to execute customer orders at the inside quote at the open.

For example, say a market maker has a bid to buy WXYZ stock at $51, but the inside market at the open is a bid of $50 and an ask of $50.25. The market maker would buy the stock from its own customers at $50.

Theoretically, therefore, there is a single opening price for each Nasdaq stock just as there is for each NYSE stock. It's the price at which the first trade is executed at 9:30. Indeed, many data systems quote an opening price for each Nasdaq stock.

But unlike the NYSE, that is not a formal price, and there is no guarantee that all orders will be executed at that price, critics say.

And even with the inside-market order-filling rules, Nasdaq market makers can make a lot of money by influencing the opening prices of shares, critics say.

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