A brief history of electronic trading for day traders

Learn how stock trading has changed over the years which especially affects day traders

Active trading is not new. It has been around for well over 100 years in this country. The only problem was you had to live in the city of New York or Chicago to be a successful day trader back in the early 1900’s. There were however, smaller town “stock trading” houses known as Bucket Shops. These operations were more like off-track horse betting parlors. Because there was no real stock changing hands at these places, they relied on ticker tape information that was delayed many minutes to follow the price movements. The Bucket Shops gave customers heavy leverage to “trade stocks”. The CFD market of today is now an electronic version of the old Bucket Shops 100 years ago.

The stock market crash in 1987 changed everything

New York Stock Exchange (NYSE)
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Day trading or daytrading (as some spell it) was for the most part relegated to professionals who had access to the markets with no middleman taking a bite out of the transaction. Up until 1987 this was pretty much the way it was. That all changed on October 17, 1987 when the stock market crashed. On that gut wrenching day, the big customers of the brokerage houses were getting out while the “little guy” was left to hold on the phone as the panic ensued. There was no way for the small orders of 1 to 5,000 shares to get attention. The phones were literally left to ring off the hook. Because of this breakdown in the system, the SEC put rules in effect to protect the small investors.

The Small Order Execution System or SOES was created to electronically match orders not greater than 1000 shares. It was essentially the first direct access trading system for small traders located in offices around the country. Although it was designed as a fail-safe system to protect the small investors, it quickly became the main vehicle for electronic day traders. Order entry specialists would take orders as traders shouted at them to execute, cancel, or change their orders. Never again, would the market see bid ask spreads half a dollar wide for big cap liquid stocks.

Stock Market Prices
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The days of easy money for the stock broker were beginning to wane. What was once a spread of 50 cents is now more than likely 1 penny wide. Since it was the broker who bought on the bid and sold on the offer to their own clients, they were making a killing for themselves.

For whatever the reason, the college town of Austin, Texas became the hub for electronic day trading. Brokers in New York were amazed at how these orders would come in and hit them for 1000 shares at a time. The SEC had mandated that NASDAQ dealers continue to make a market by advertising a bid and offer that could be accessed by SOES. They had no choice but to let these traders hit their advertised price, then quickly sell as the price moved up a quarter dollar or more using SOES to hit the bid and get out with an easy profit. In fact day trading back in the day of SOES was too easy!

Retail day trading floors began to open

Public Library
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Around 1996, retail day trading floors began to open up to the public. Starting mostly in Texas, they migrated into most major cities across the country. They became modern day Bucket Shops, only this time real stock was being traded with information in real time. Things were going great. It seemed everyone was in the market and making money. Just buy and keep buying. Then 2000 came along and wiped out many traders. Those who refused to turn around and change their strategies were slowly stopped out of trading.

Around 2002, it got even harder when the whole stock market went to decimals. Why was this such a defeating move for many day traders? Before this time, there were only 16 price levels in a 1 dollar move. Stocks traded in fractions of 1/16 or “teenies” as they were called. Making a “teenie” was easy money if you knew what you were doing. Making 4 “teenies” was not uncommon. That’s a 25 cent move with only 4 price levels! Now there are 100 price levels to negotiate! More noise and variables were added to the markets as the spreads continued to narrow.

Pattern Day Trading Rules

Domino
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Some of the latest changes to the markets started in Pattern Day Trading Rules. You must have 25k in your account to qualify as a day trader who can execute numerous trades in one day without a problem or a margin call. There are a few exceptions to this rule. If you are part of a capital pool account, that pool account may qualify in total to satisfy the SEC. The next big change was the abolition of the Uptick Rule. This has allowed many short sellers to “pile on” the markets without having to wait for an uptick in the time and sales prints. Which in turn has led to increased volatility in the markets.

Finally, Dark Pool orders are becoming a difficult environment for decoding who is a buyer and who is a seller. These are pools of liquidity that are not seen in the national level 2 quotes. They are invisible orders sitting there waiting to be matched by the computer algorithms and ECNs. They are required to report the sales to the Time and Sales immediately. If you watch closely on a level 2 screen with Time and Sales, you will see some trades go off in between the inside market quotes. This has made it hard for the old school professionals who relied on identifying who the buyers and sellers are.

Computer algorithms are taking over the markets

Computer Algorithms / Electronic Trading
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Today the landscape of the day trading market is very different from just 10 years ago. Computer algorithms are executing trades. Black Box and Gray Box trading systems are becoming more advanced and more widespread. Gray Box refers to the computer executing a trade and then having a human trader exit the position. Black Box trading is where the computer does everything. The entry and the exit are written as a formula that sometimes has 30 steps involved before a trade is executed. The issue with robot trading is that the daytrading system has to evolve with the markets. No single system will work all the time. The markets are ever changing. In fact change is the only constant.

About Steve Gomez
Steve Gomez is a professional trader and mentor from San Diego.

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