Why traders die broke By Gretchen Morgenson
With spreads like these, who needs a bear market?   

PICTURETEL isn't exactly obscure. The company is a leader in videoconferencing equipment; it has 12 analysts following it; and the stock trades an average of 486,000 shares a day. So why is it so costly to get in and out? On an uneventful trading day in April the spread between the bid and the ask was a stunning 5.5%. If you want to trade this stock, you have to wait for it to go up 5.5% just to break even. PictureTel has company, as you can see in the table on page 248. All these Nasdaq stocks are heavily traded; how-ever, on that day in April, they carried bid/ask spreads topping 2%. What's the point of shaving a few dollars off your commissions if you are going to get killed on the spreads anyway? Discount brokers, it must be noted, are not sympathetic about your plight. The largest discount broker, Charles Schwab & Co., owns a large over-the-counter marketmaker, Mayer & Schweitzer. When you take a trade in Vivus or Medaphis Corp. to Schwab, Mayer & Schweitzer usually pockets the spread. Spreads between the bid price (what you receive when you sell your stock) and the ask (what you must pay to buy) have a way of coming out much fatter on Nasdaq than on the New York and American stock exchanges. Wasn't the recent SEC-mandated reform supposed to change all this? It did, but only up to a point. Although spreads have narrowed by 30% on some of the larger Nasdaq stocks like Intel and
Microsoft, overall spreads there are still much higher. In April the average Nasdaq national market stock carried a spread of 45 cents. That's double the AMEX's 23 cents and the NYSE's 19 cents.   

  This problem is compounded by the fact that on Nasdaq it is tough to keep the middleman, or marketmaker, from getting in the middle of your trade and taking his piece. You can avoid that on the NYSE and the AMEX, and indeed that is what happens 80% of the time on those exchanges. Example: Exxon is quoted by the Big Board specialist as 575/8 to 577/8. If you must sell 1,000 shares immediately, you hit the bid. Eight times out of ten, the person buying your stock will be a public investor; the other times, the specialist pays you the 575/8 per share and takes the stock into inventory. Conversely, if you are in a buying panic, you grab 1,000 shares at the asked price of 577/8. But you don't have to trade this way. You have the right to place a so-called limit order smack in the middle at 573/4. In that case your order sits and waits. Say you are buying. If a seller willing to take your price comes along, the 1,000 shares change hands automatically. Brokers on both sides make their usual commissions. The specialist usually makes no commission and never the spread. Why should he? He took no risk, and the work was done by a computer. As we said, this is the usual way of doing business on the floors of the New York and the American stock exchanges. On Nasdaq, it's been the exception. As of July over-the-counter marketmakers in 700 of Nasdaq's 5,500 stocks will be obliged to display publicly investors' limit orders priced at or better than the market if the marketmaker chooses not to execute the order immediately. Therefore, if you're a buyer, your order will either be filled immediately or will be displayed openly so that anyone interested in selling the stock to you at your price can do so. Ditto if you're selling. What about the other 4,800 stocks? On these, marketmakers will continue to collect their pound of flesh until they are phased in, it is hoped, by the end of 1997. At that point—if you specify clearly that you want to place a limit order—it will be posted. Place a blank-check market order and you pay whatever spread the traffic will bear. Do this only if you absolutely must get in or out immediately. Why does any Nasdaq stock still carry a wide spread? Dean Furbush, chief economist at the National Association of Securities Dealers (NASD), has three excuses. The first is that larger spreads are justified on higher-priced stocks. Okay, but many stocks with wide spreads are priced at $20 or less. Second reason: volatility. If a stock moves around a lot, the marketmaker who buys and sells from investors has a greater risk of losing money effecting those trades than he does if a stock trades in a fairly narrow range. Third, slim volume. If a stock does not trade a lot, says Furbush, the marketmaker needs a better spread to compensate him for holding the shares in inventory for a comparatively long time. Furbush brags about the new low spreads as if it were Nasdaq's idea to implement the order-handling rules. In fact, the rules were forced on Nasdaq by the SEC, when it sued the NASD in 1996 for having treated small investors unfairly for decades. Even after a year of "reform," the Nasdaq market has a long way to go before it's an efficient, inexpensive place for investors to trade stocks. Over-the-counter stocks are fine for the buy-and-hold investor. Active traders, though, must be extra vigilant. Here's some advice: • Don't assume that just because a spread was one-eighth yesterday, it won't be three-eighths tomorrow. Spreads vary from day to day, even from hour to hour. • If you're pitched an over-the-counter stock by a broker, ask what its spread is as a percentage of the bid price. If it's greater than 1%, that's high. If you're interested in cutting your trading costs, stick with stocks listed on the exchanges or with Nasdaq stocks that trade with one-eighth spreads. • on stocks with wider spreads, don't trade through a discount broker. Even if the new order-handling system works beautifully, you will still be better off placing your orders to buy and sell through a full-service broker willing to watch over your order and "work" it if the market moves against you. Discount brokers, as order-takers, are less inclined to follow an order through to make sure it gets executed at a better-than-market price. • Steer clear of bucket shop brokers claiming to sell o-t-c stocks on a no-commission basis. Those guys are not in business for your health. A hefty spread usually lurks in stocks sold this way. You won't see it on your trade confirmation because it is not, strictly speaking, a commission. • Be especially cautious before going into high-multiple technology stocks and momentum plays. Note that a lot of the offending spreads in the table are on hot stocks of this type. These stocks are very popular among individual investors. Not only are these stocks expensive on a valuation basis, they are costly to buy and sell. It's easy to forget this after so many years of a steadily rising stock market, but these are two very sure ways to go broke.     

With spreads like these, who needs a bear market? Trading costs remain a problem in some Nasdaq stocks, even those that trade fairly frequently, like these. Traders beware.


  1. What is the bid-ask spread? Why is a cost of trading?
  2. Why would these costs be higher for over-the-counter stocks?
  3. Why is the spread a greater consideration for active traders?