Path: bloom-picayune.mit.edu!snorkelwacker.mit.edu!americast.com!americast.com!americast-post Newsgroups: americast.ibd From: americast-post@AmeriCast.Com Organization: American Cybercasting Approved: americast-post@AmeriCast.com Subject: \TITLE Date: Wed, 11 Nov 92 12:52:31 EST Message-ID: <6.1992Nov11.125231@AmeriCast.com> 11/11/92 TITLE #m#gm#m#Watch Costs When Buying A Nasdaq Stock Lance Ignon So you've got your eyes on a hot, young growth stock. The company's earnings look good, it has a dynamite product and its stock is hitting new highs like a sharpshooter. Time to buy? Maybe, but before you put in your order, make sure you have con- sidered the full purchase price. While investors always weigh a security's price and commissions, they sometimes overlook the spread. "And yet it's extremely important," said John Markese, president of the American Association of Individual Investors. "You can get eaten alive on the spread alone." The spread is the difference between the "bid" - what traders will pay for a stock - and the "ask" - what they will sell it for. The wider the spread, the costlier the transaction. Take United Wisconsin Services Inc., a health maintenance organi- zation whose stock pushed dramatically higher during the summer. United Wisconsin's stock yesterday had a bid of 28 and an ask of 291/4 - a hefty 11/4-point spread. In other words, you would pay 291/4 for each share. Sell it a few moments later and you would get 28 a share. To get a better handle on the costs of the spread, divide it by the bid. In the case of United Wisconsin, that equals 4.5% (1.25/28 x 100). In other words, the stock would have to gain 4.5% in order to break even, and that doesn't count commission costs, which average another 4% for a full- service brokerage. "You have to have an awfully big winner," to make up for a big spread and other costs, Markese said. "I always tell people who are starting out in Nasdaq stocks to ask: 'What would I get if I turned around and sold this stock right now after buy- ing it?' It's an eye-opener." Although some market analysts argue that the Nasdaq's over-the-counter system leads to wider spreads, four factors inherent to all trading mechanisms are the major in- fluences: Volume: The more a stock trades, the tighter the spread. That's because greater liquidity reduces the risks a trader takes when holding an inventory of a given issue. Volatility: The more a stock's price fluctuates, the wider the spread. Again, this reflects the risk of holding the stock Watch Costs When Buying A Nasdaq Stock in a brokerage's inventory. Price: Lower- priced stocks tend to have higher proportional spreads. Cheaper issues tend to be less liquid and represent more speculative, and therefore volatile, companies. Number of Dealers: More market-makers means more competition and less ability on the part of one dealer to widen the spread. This applies only to stocks traded on the Nasdaq, which uses more than one market-maker for each stock. Some of the widest spreads are found among Nasdaq stocks. This is due in part to the Nasdaq's higher number of less liquid, lower- priced stocks. This logic also explains why the less liquid Amer- ican Stock Exchange issues also tend to have bigger spreads. Yet some market analysts argue that the Nasdaq's market-maker system actually promotes higher spreads than those found on the NYSE. "Not only does it feel like" spreads are higher on the Nasdaq, "there is absolutely an incentive for that to be the case," said Charlton Reynders, chairman and chief executive of Reynders, Gray & Co., an investment management firm and member of the NYSE. To understand how the two systems vary, consider what happens when you walk into a brokerage to buy a stock on the Nasdaq and one that trades on the NYSE. An order for an NYSE stock passes through a broker to a single specialist on the floor of the ex- change. As such, there is only one bid and one ask displayed in the specialist's limit-order book. If you don't like the asking price, you can always submit a bid in between the spread, which will then be displayed to all potential sellers and buyers. If a seller takes the lower offer, the spread effectively has been tightened. On the Nasdaq, your order will go to a series of market-makers linked by a geographically diverse network of com- puters. Each market-maker offers his or her own spread, although competition among firms tends to pack the bids and asks into a fairly narrow range. Still, an unsuspecting customer may end up paying a slightly higher price if his broker fails to buy at the lowest asking price. Unfortunately, there is sometimes an incen- tive not to get the best price, Reynders said. Market-makers keep an inventory of stocks for their own accounts. If a dealer has a long position in a stock, he may be willing to sell at a lower price just to get rid of some of this inventory. However, the opposite might be true when he is short. "This doesn't have a lot to do with supply and demand," Reynders quipped. For exchange-floor specialists, profits come from commissions. But the bulk of earnings for market makers come from the spread. Again, it's another disincentive for lower prices. That said, recent studies have shown that there is no difference in spreads when comparing stocks of equal liquidity and representing equal- sized companies. A recent study of the spreads of similar stocks that traded on the Amex, NYSE and Nasdaq during two months in 1985 showed a slightly narrower spread for the Nasdaq issues. However, the results may have been skewed by the inclusion of Amex issues, which tend to have much wider spreads than those on the NYSE. Nonetheless, the study confirmed that liquidity and type of company were the leading determinants for the spread. "When we controlled for firm size and price and volume, then we found no difference in the spread," said John Affleck-Graves, an associate professor at Notre Dame University and one of the study's three authors. That's not much consolation, though, for investors interested in the smaller Nasdaq growth stocks that have no counterparts on the NYSE. But there are some precautions that can help reduce exposure to a yawning spread. Develop a good relationship with a broker who deals exclusively in smaller stocks. If you do enough business with him or her, try bargaining down the price of the spread. Institutions do it all the time. Consider using the Nasdaq's Small Order Execution System or SelectNet. The SOES guarantees that orders under 1,000 shares will be executed at the lowest offered price. It also allows you to put in a limit order between the spread, although there is no guarantee that it will be executed. SelectNet is a similar system for larger orders. This article is copyright 1992 Investors Business Daily. Redis- tribution to other sites is not permitted except by arrangement with American Cybercasting Corporation. For more information, send-email to usa@AmeriCast.COM