What to Know as Nasdaq Trades In Its Old Ways for Fairer Ones

The Nasdaq Stock Market, which for years has suffered a largely deserved image of being rigged, is about to become a much fairer place for individual investors.

That’s the plan, anyway, if some monumental changes in the trading of Nasdaq stocks can finally be implemented. They were supposed to take effect on Monday. The new effective date is Jan. 20, as approved by the Securities and Exchange Commission late Friday.

The technical difficulty in bringing the changes to fruition says something about how dramatic they are. The electronic Nasdaq system, a market made up of hundreds of brokerages linked nationwide by computers and telephones, has for its entire 26-year history operated on the principle that the brokerages themselves control pricing--the “bid” and “asked” levels of Nasdaq-traded stocks.

The changes to be phased in starting Jan. 20 will allow small investors to get “inside” those brokerage-set bid and asked prices, something institutional investors have been doing among themselves for years, and something that has long been standard practice on the New York and American stock exchanges. Essentially, the public now will get the opportunity to determine second-by-second prices for Nasdaq stocks in a way that was never possible before.

“This is going to change the whole nature of this marketplace,” says Jerry Markowitz, director of capital markets for Montgomery Securities in San Francisco.

One result, naturally, should be better prices to investors, whether they’re buying or selling Nasdaq stocks. But some Wall Streeters warn of other potentially unpleasant side effects as well: more volatility in stocks’ prices, higher commissions, and less sponsorship of many of the thousands of mostly small stocks that make up the Nasdaq market.

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That some brokerages should regret the end of the old Nasdaq system isn’t surprising, given how lucrative it has been for them, especially as it has grown to become the nation’s busiest securities market, with 5,540 stocks listed.

It took a Justice Department investigation into Nasdaq pricing to finally force the system down the path of reform. Now that the change has come, however, the individual investors who stand to benefit most from the new Nasdaq pricing system will need to learn how to properly use it.

The initial phase of the changes will involve just the 50 most heavily traded Nasdaq stocks--names such as Intel, Microsoft, Sun Microsystems and Amgen. Other stocks will be phased in over the next few months, and by Aug. 28 the new trading rules will apply to all Nasdaq stocks.

There are many aspects to the Nasdaq changes, but here are four key points investors should understand:

* A “limit” order now can be a useful tool. With a limit order, you specify to your broker the price at which you want to buy or sell a particular stock. The alternative is a “market” order, which is an order to buy or sell immediately at the best possible price.

Many investors have long shied away from using limit orders with Nasdaq stocks, for a simple reason: The brokerages that make markets in individual Nasdaq issues--and which set the bid and asked prices--could in effect ignore limit orders that were better than the brokerages’ prices.

Jim Angel, assistant professor of finance at Georgetown University and an expert on stock market structures, illustrates the current system like so: Say a brokerage lists a Nasdaq stock at $10 bid, $11 asked. That means individual investors who want to buy the stock would pay $11 and investors who want to sell would get $10. The $1 “spread” is the brokerage’s profit.

If an investor tries to get inside that spread--say, by offering to pay $10.50 for the stock, which is better than what the brokerage is offering--the current system doesn’t require the brokerage to display that offer to other investors. As Angel puts it, the brokerage “could stick that order in its pocket and never tell anyone about it.”

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Under the new system, any limit order for at least 100 shares must be displayed to the entire market if the brokerage receiving the order chooses not to execute it at the price specified. Brokerage bid and asked prices will still be there, but suddenly the sun will be shining on prices in between those quotes. The result should be better stock prices, as investors are able to match up at prices inside the official spread.

* With total visibility for limit orders, brokerages’ “market-making” function should lessen. Not only will investors now be able to see other individuals’ and institutions’ best offers to buy or sell Nasdaq stocks, but your broker also will be required to tell you how many shares are available at the best buy/sell prices of the moment.

That information should make it easier for Nasdaq stock investors to trade with each other, rather than directly with the brokerage market makers. Thus, brokerages will be forgoing some of their traditional profit on the bid/asked spread. And that has raised fears that liquidity for many Nasdaq stocks will dry up if more brokerages decide it isn’t worth keeping meaningful inventories of shares because they can’t earn the same bid/asked spread profits.

Nasdaq President Alfred Berkeley says he thinks most brokerages “are taking a ‘let’s try this’ attitude” for now. But it remains to be seen how many brokerages will cut back their market-making function--and whether Nasdaq stock prices could become more volatile because of that.

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Paul Schultz, finance professor at Ohio State University and a longtime critic of Nasdaq pricing, isn’t too worried about market makers falling away. If investors can display their best limit orders to each other, he says, “what do we need market makers providing bad [bid/asked] prices for?”

But Georgetown’s Angel is concerned that for the smallest, least-liquid Nasdaq issues--those whose spreads have been widest, and therefore most costly to investors--a decline in market-making activity by brokerages could hurt the stocks. “Little stocks don’t necessarily sell themselves,” Angel says.

* Limit orders won’t be a panacea. Just because small investors now can place a limit order--and know that it will be seen in the market--doesn’t mean that a limit order is the right order whenever you’re trying to buy or sell a Nasdaq stock.

For one, individual brokerages may set their own rules about the type of limit orders they’ll take from clients (i.e., how thinly they’ll allow customers to slice a buy or sell price within the existing bid/asked spread).

In addition, realize that if you enter a limit order, it may never be executed: No one may be interested in your price, or the stock may move quickly up or down, leaving you too far from the market.

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Angel says that investors who are in a hurry to get into or out of a stock should stick with market orders, which assure that the trade will be done quickly, although you won’t be sure of the price.

“But if you’re not in too much of a hurry, put in a limit order between the bid and the asked price” and see what happens, Angel says.

* Your commission costs may rise. Because Nasdaq investors now will be trading much more among themselves and because increased use of limit orders should have the effect of forcing brokerages to narrow their own bid/asked spreads, the business of market-making and trading Nasdaq stocks probably won’t be as profitable for brokerages.

That could cause some firms to raise their commissions on Nasdaq trades. In the case of brokerages that wholesale stocks on behalf of other firms, Berkeley says some of those wholesalers have already begun charging other brokerages to accept limit orders, where in the past the wholesalers had paid small fees to get those orders.

But if Nasdaq investors are getting better prices per share when they buy and sell, that should offset much or all of any rise in commissions--at least, that’s the hope.