As our country tries to regain balance in today’s increasingly unstable economy, businesses everywhere are succumbing to bankruptcy. Although no one likes to see our economy struggle, day-traders have a unique opportunity to make the best of a bad situation.

In late November, American Airlines (AMR) crashed as the company filed for bankruptcy, dropping 88% from $1.62 to $0.20 as scrambling shareholders oversold short. What many day-traders do not know, is that AMR was destined bounce back almost immediately.

In the past 30 years, a trend has developed where stocks of big businesses filing for bankruptcy will come back up an average of 18% within a week of the initial crash. This has proven true for the 20 largest corporations in the United States to file bankruptcy since 1980, according to Bloomberg and Bankruptcy.com.

This theory held fast for AMR, as it jumped back up almost 100%, from $0.20 to just under $0.40 in the two days after they filed. In 2009, the same trend applied to the General Motors crash (GM) and Sirius XM Radio (SIRI).

The bounce back trend develops when traders try to catch the stock on the counter trend. Market makers anticipate this exaggerated move, and force the stock to rebound by purchasing shares at the after-crash prices.

Traders should take caution though; this is not a type of stock you should hold on to. These stocks behave like a super ball thrown out a window; it will bounce back up, but will fall again and the recurring bounces will never reach the original price.

Day-traders should be aware of this trend, and take advantage of it when big business catastrophes are reflected in their stocks as tremendous short term gains are almost always guaranteed.

To be a successful trader in this market, you need to have the right tools. One of the most important, in my opinion, is a Level II window. Level II controls the whole market; it influences charts, time & sales, indicators and Top (or Hot) Lists. The reason the Level II (Market Depth) window is so important is because it also allows you to see the Electronic Communication Networks (ECNs), the Market Makers (brokerage firms), the price at which they want to buy or sell a share and much more. In other words, without knowing how to trade with Level II, you're trading blind!

I use Level II as the key to my main day trading strategy. Once I find a stock to trade, I look for the Market Maker trading that stock. That's what makes Level II data so important to me. Level II is what I use to see what the ECNs are doing (ECNs are more important than the Market Makers because the Market Makers are also using the ECNs) to see the big block trades. I then use the Market Maker orders on the level IIs to confirm the support and resistance levels on my charts.

The great advantage of having an eSignal platform is that it offers the Market Depth window with Level II and ECN quotes, allowing me to see the Market Makers, so I can shadow them on the bid and ask, and also see those ECN big block orders. I am one of the original day traders from the early 1990s and have been using Level II since I started, more than 16 years ago.

Because I know how important it is to use the Level II window and how to strategize with it, I try to share this knowledge with my students at Cyber Trading University. Many new traders don't understand the importance of the Level II window, so, as I teach them, I try to show them how, without Level II data, they are in for a lot of unwelcome surprises.

The hottest news source for traders these days isn’t Reuters or Bloomberg or Business Wire. 

Instead, it’s the Obama Wire. 

Perhaps at no other time in history have traders been so attentive to what a president is saying or doing – and making so much money from it. Indeed, the Oval Office has become a rich source of trading ideas for those smart enough to be paying attention, and savvy enough to profit from it. 

Like it or not, some of the sharpest minds in the country – and in the world – work on Wall Street. Many of them are traders. They not only understand how to spot opportunities, but how to capitalize on them. And, with President Obama’s broad agendas impacting so many industries, traders are having plenty to work with. 

But, as I teach my students, you don’t have to be a political junkie to know what’s going on. You simply need to have an overall grasp of the present political picture, and be aware of whatever Obama is talking about – or even rumored to be discussing – during a given day or week. 

For instance, when the president takes aim at the larger financial institutions, it frequently causes their stocks to become volatile, and creates excellent opportunities for traders. When the president appears to be favoring changes that will negatively impact this group, these stocks go down – sometimes sharply. This is especially true whenever the president appears to ratchet up the intensity or strongly voice his opinion during a speech, rally, or some sort of event. 

And, as almost always happens, when one group gets hits, another goes up. In this case, the stocks of smaller banks often shoot up as their bigger brethren nosedive. 

The same volatility occurs in other industries, too, such as automotive, health care, insurance, and alternative energy. It seems whatever the president is talking about at the moment becomes the beneficiary of stock movement – higher or lower. 

Keep in mind this isn’t just “trading the news.” It’s less obvious than that, and requires more insight. It’s being aware of the subtle – or sometimes less subtle – changes that occur in the president’s stance on issues, and being prepared to take action based on that. 

It’s not important whether you agree with the president’s current view on an industry, or about possible rule changes that could affect these fields. Your job as a trader is to identify promising trading opportunities, and then exploit them. And, remember, volatility is your best friend. As a trader, you should want a president who’s very active and seeks widespread change, as that creates movement in the stock market. 

So, stop waiting for your personal stimulus package. The government isn’t going to provide you with one. Instead, create your own stimulus package by making profitable trades that are linked to whatever the Obama Wire is indicating. 

After all, there’s nothing more American than capitalizing on opportunity. 

Fausto Pugliese is the founder and president of Cyber Trading University, a world leader in online education and training for traders and investors in the markets. You can reach Fausto at faustop@ctucorp.com, follow him on Twitter and Facebook, or listen to him on CNN Radio.

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"The foundation of Cyber Trading University is their vast array of online courses and educational DVD’s designed to fit the needs of active traders. Professional instruction is available to both part-­time and full-time traders whether they are seekign a career as a professional day trader or assistance as an active investor. Courses are structured based on a student's skill level and experience from beginner to advanced Master level studies. Instructors are required to meet the minimum requirement of 8 years professional trading experience and must pass the CTU qualification assessment exam. The faculty at Cyber Trading University share a common dedication to teaching and the desire to ensure students receive the highest quality educational experience in the industry."

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I love being a day trader!  I love the thrill of the hunt in trying to find tradable stocks.  I love the cat and mouse games with the market makers.  And I like being my own boss and having the ability to determine how much I get paid on a given day by the decisions I make.  As a result, I look forward to getting up in the morning on trading days.  On those days when the market is closed, I often miss it.  There’s simply no other way I’d like to make a living.

If you’ve been trading for any period of time and you don’t feel this way, then this is not the career for you.  And that’s okay.  We certainly couldn’t have a country of people just day trading.  We need doctors, accountants school teachers, policemen, waitresses, etc.

And while I’m not sure that anyone should spend 8-10 hours a day doing something they hate for a paycheck, this is certainly the case for day traders because, after all, there is no paycheck; at least, not a guaranteed paycheck.  There are many days when I work all day with nothing to show for my efforts.  In fact, being a day trader is one of the few professions in which you can work hard all day and actually come home with less money than when you started the day.  Doing this job just for the money is a sure fire recipe for disappointment on all counts.

 After all, you probably won’t make much of a day trader unless you love it anyway.  This is the case with any profession.  The most successful people are those who have a passion for it.  You need a passion to get up when many people are sleeping and search the market for potential stocks to trade.  You need a passion to follow several different stocks at a time.  You need a passion to bounce back after a losing day.

And even if you are that rare breed of person who can excel at doing something you hate, I have to ask, “Why?”  And no, “the money” isn’t an acceptable answer.  For one, this is America.  There are countless ways to make money in this country.  Why choose a way that makes you (and likely, everyone around you) miserable?  Second, it’s only money.

Yes, you read that correctly.  It’s only money.  Now, I know that you wouldn’t expect to read that phrase from someone who makes his living in the market, but it’s true.  Sure, I like money.  I think it’s a good thing.  It’s necessary for many of the necessities of life – a home, a car, food, utilities, you name it.  Yet, money pales in comparison to some of the really important things in life.  I wouldn’t trade my wife for any amount of money.  The same is true for my children, my parents and my close friends.  And certainly, the same is true for you.

There are some things that money can’t buy in your life.  If that’s true, then you certainly don’t want to sell your actual life for money.  You don’t want to spend the vast majority of your waking hours doing something that you don’t love just for the money.  As I see it, when it quits being fun, you should quit. 

Now, of course, even if you absolutely love day trading, you run the risk of burning out from time to time.  This is why it’s so important to take time off.  Take a vacation with your family, go hiking in the mountains or just spend some time with a good book in your living room.  The important thing is to get away from your computer for a while.  These hiatuses from trading will not only prevent burnout but they will make you more profitable in the long run.

Many day traders think that the most productive thing they can do at any minute is to trade.  However, in some cases, actually the opposite is true.  Sometimes, the worst thing that you can do is to continue trading, particularly when you need a rest.  This principle is probably best illustrated by the old story of the two lumberjacks who had a competition to see who could saw the most wood in a day.

The first man was young and strong and no doubt had the greatest endurance.  The second was not as young and not as strong, but had years of wisdom on his side.  The first man worked furiously during the contest not stopping for a single break.  In contrast, his more seasoned opponent, would took a break almost every hour.  At the end of the day, the young man had cut down an impressive number of trees, but the older lumberjack had clearly won the contest.  The young man couldn’t believe it.  In his frustration, he asked the older man, “How could that be?”  The old lumberjack replied, "Did you notice that every time I was sitting down, I was sharpening my saw?"

Likewise, if you want to make the most of your day trading, you must stop to sharpen your saw from time to time.  You won’t believe the insights you will get about trading from not doing it for a little while.  It’s true.  Some of the best lessons I’ve learned about trading have come while I was jogging, fishing or [whatever hobbies you actually do].  The answers just seemed to come to me after I spent some time “sharpening my saw.”

The same will be true for you.  More importantly, taking a little time off will recharge your batteries and hopefully, give you renewed zest for getting back into the market.  And that’s really what it’s all about anyway.  After all, if you truly love what you do, then you never have to work a day in your life.  So let’s all go play, shall we?

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In a previous article, I strenuously warned against the temptation of holding overnight positions.  When I give my top ten rules of day trading “don’ts”, no overnights is Rule #1-5.  A close second (or I guess, sixth) is no dollar cost averaging.

As you probably know, dollar cost averaging is the process of buying additional stock after you’ve taken a prior loss.  The rationale for doing so is that, now that the price has been “discounted,” you can buy more of it and therefore, increase your chances of making a profit (or at least breaking even).

If you’ve ever dealt with a stockbroker, then you have very likely been introduced to this strategy.  That’s because dollar cost averaging is written on Page 1 of the Stockbroker’s Handbook under the chapter “They’ll Fall for It Every Time.”  It works like this:

Your broker calls and pitches XYZ stock.  According to your broker, this company has the greatest product, management and marketing strategy.  It is going to revolutionize its industry.  The broker is so excited about the stock that he has not only put all of his money into it, but he has put his dear old grandmother’s retirement fund into the stock.

You figure that he wouldn’t steer his grandmother wrong, so you buy 1,000 shares at $30 per share.  Over the course of the next few weeks, the stock price falls to $15 per share.  You’ve lost $15,000 or half of your original investment.  You think to yourself, “My broker’s poor granny.  Her retirement fund was wiped out!”  Well, perhaps that isn’t your first thought but you are distraught nonetheless.  You just sit in your office thinking, “How could I have been so stupid?”

Yet, you are awoken from your trance by the telephone.  It’s your broker on Line 2.  You can’t believe it!  After such terrible advice, you didn’t think you’d ever hear from him again.  You’re even more shocked when he calls to tell you the “good news” – that XYZ has lost half of its value.

“That’s good news?” you practically scream into the phone.

“No, it’s great news!” he responds, practically reading word for word from the handbook.  “If you thought XYZ was a good investment at $30 per share, it’s a ‘steal’ at $15 per share.  For the same $30,000, you can now buy 2,000 more shares of stock.  In that case, if it just goes back up to $20 you’ll break even.  If it goes back up to $30, you’ll be up by $30,000.  And if it goes up to $50 (and the broker is sure that it will), you will make … get this … $90,000!  You just have to buy more shares!  It’s a no-brainer!”

Now, here’s the weird part – you probably will buy more shares.  Why?  Because if you are like most people, you can’t stand the thought of cashing out a losing investment.  After all, the point of buying stock is to buy low and sell high.  Yet, up until now, you’ve done just the opposite.  However, by dollar cost averaging down the price of your investment, you increase the chances that you’ll eventually break even, if not make a profit.  So why not, right?

Wrong!   The poor house is full of people who dollar cost averaged away fortunes.  They kept buying stocks like Enron, Global Crossing and Worldcom all the way down to zero.  In many cases, they did so at the advice of a stockbroker, who, by the way, earned a commission on every trade.

Of course, as a day trader, you won’t have an outside stockbroker trying to talk you into dollar cost averaging.  Yet, you will have an “internal stockbroker” trying to talk you into doing so to avoid cashing out a losing position.  For example, let’s suppose you buy 1,000 shares of a stock at $19.00 and it falls to $18.10.  You’re down $900.  At this point, your internal stockbroker might try to talk you into buying another 1,000 shares with the thought that you can wipe out your loss if the stock just inches up another $0.45 to $18.55.

Hang up the phone!  Sure, the stock may very well inch back up, but it isn’t worth the risk.  Think about it.  You’re putting an additional $18,000 on the line to avoid a $900 loss.  In all, you could lose as much as $37,000 (remember, you invested $19,000 on the first trade) just because you’re unwilling to accept the loss of $900.  That just doesn’t make sense.

And, I know, you’re sure the stock is going to rise, right?  Or are you?  You didn’t have a good grasp on the direction of the stock when you bought it the first time.  Why do you think it will be any different this time?  Wouldn’t it be better to just consider it a lesson learned and be done with it?  In the overall scheme of things, $900 is a very inexpensive lesson.  Why make your loss almost 400 times greater to learn the same lesson?

One of my friends learned his lesson in the hardest way imaginable.  He bought 2,000 shares of a stock, which went down $2.00 per share.  His total loss at that point was $4,000.  Yet, this guy wasn’t willing to take this loss so he bought more shares.  The stock fell again so … you guessed it … he bought more shares.  He kept dollar cost averaging until he turned 2,000 shares into 8,000 shares and a $4,000 loss into a $75,000 loss.

But there’s more to the story.  Eventually, the stock came back to within 25 cents of the break-even point.  Looking at the charts, I noticed that the stock was near its resistance and asked my friend if he was going to take his loss.  I’ll never forget his response.  “Are you kidding, Fausto?  If the stock just goes up a point, I’m up $8,000!”

Well, once again, you can guess what happened.  The stock knocked against its resistance level and went into a tailspin.  It fell so far and so fast that my friend ended up losing $150,000, which included his wedding money.  In the end, he did not get married to his fiancé.

Think about this for a moment.  My friend’s entire future was changed, in part, by his unwillingness to take a $2,000 loss.  Don’t make the same mistake.  When you are wrong about a stock (and you will be), don’t turn a small loss into a big one.  Simply cash out the position, take your loss and move on. 

» Click here to sign up for my free beginner stock course titled "Introductory Course for Traders and Investors" now

Perhaps you’ve heard about a proposal to levy a tax on stock transactions. This idea actually began circulating about a year ago as a way to curb “speculation” in the market, subdue the market’s volatility, and raise tax revenue, according to its proponents. But, the notion resurfaced recently due to a push by the AFL-CIO to make such a tax a reality. Specifically, the powerful union would like to see a one-tenth of a percent tax on every stock transaction. According to union officials, doing so could raise as much as $100 billion a year in tax revenue.

Now, if you’re not an active trader, you might be tempted to think such a tax wouldn’t affect you. But, you’d be wrong – very wrong. Basically, this tax would impact you as long as you had money in the stock market – even if you’ve never made a trade in your life.

But, first let’s look at how it would impact individuals who trade from their homes, either as a hobby or as a career.

This tax would be on every stock transaction – meaning that if you bought a stock and then sold it, you’d be paying this tax twice.

On top of that, some of these proposals have the tax being applied to the transaction amount. So, let’s say you bought 1000 shares of Microsoft (MSFT) at $25. Your transaction amount would be $25,000. With this tax, you’d be paying a $25 surcharge on this purchase alone.

Imagine how this would penalize daytraders and other types of traders who make anywhere from several trades to hundreds of trades per week. And, remember, traders already pay taxes on every trade they make. But, you’re not a trader. So, why should you care what happens to frequent traders? Because the impact of the tax wouldn’t stop there.

Such a move would likely force many active traders out of the market. This alone would lead to less liquidity in the market – which would actually exacerbate the volatility in the market. And, the illiquidity would lead to bigger spreads – that is, the difference between the bid and the ask price. Which means that when you tried to buy a stock for your retirement portfolio – or when your financial advisor or mutual fund manager did the same – there would be a higher price to pay for that stock.

Speaking of mutual funds, did you know that mutual fund companies, brokerage houses, and hedge funds make an enormous chunk of their annual profits through trading – not investing? It’s estimated, for instance, that Goldman Sachs makes 70% of its annual revenue through trading-related activities. And, as for those staid, supposedly conservative mutual fund companies? On average, mutual fund managers turn over their holdings at a 93% rate per year.

Now, consider that under this tax, every time a firm such as Goldman Sachs or Fidelity or Charles Schwab bought or sold a stock, they’d be hit with an extra fee. When you consider the billions of stock transactions these and other investment firms make, the financial consequences would be alarming. Just think of the hit their profit margins would take. So, who do you think would ultimately pay for these fees? That’s right – their customers. And that means your neighbor, your co-worker, your best friend – and, of course, you. Maybe even worse, some of these firms might try to avoid this tax by rerouting their trading overseas, which would take away from the billions of dollars that the financial services industry generates for our country.

So, when you hear discussions about this proposed tax, pay attention. It’s not just some random tax that will impact daytraders – it’s one that will affect anyone who has money in the stock market. Including you. Fausto Pugliese is the founder and president of Cyber Trading University, a world leader in online education and training for traders and investors in the markets.

(Originally Appeared in Equities Magazine)

Bernie Madoff went from being a relatively unknown name with the public to a highly recognized one in just a matter of months. And, of course, for all the wrong reasons.

But, what most people don’t understand about Madoff is that he made a great deal of his wealth not through his investments, but through his market maker firm. Avid traders knew his company as MADF on their Level II screens.

If you’re not familiar with market makers or their roles, these companies are registered to act as dealers in a stock. They buy, sell, and accumulate shares in a stock on behalf of their clients or for their own accounts. They fill both market and limit orders, and provide much-needed liquidity to maintain at least some level of stability in the stocks they feature.

So, how did Madoff’s firm – as well as other market makers – make so much money?

They do so in four basic ways. Market makers capture the spread between the bid and the ask price on orders, receive commissions from large institutional clients (such as mutual funds), get order flow from brokers, and trade for their own accounts. (Madoff was instrumental in developing the order flow aspect, in which market makers would pay brokers, such as E*Trade or Schwab, to funnel customer orders to them.)

All of this adds up – to a fortune – due to the sheer amount of trades processed each day. And, with the wild volatility and big movements we’ve seen over the past year or so, market makers are really making money.

It’s fascinating to watch market makers at work. You need a Level II screen to do this, and unless you know what to look for, most of the action will escape you. But, if you have a deep understanding of what’s going on, you’ll marvel at how adept market makers are at their craft, as well as how many tricks they employ on unsuspecting market participants to create even more profits for their firms.

While you may never be a market maker like Madoff or accumulate the amount of money he once had, you can see how a market maker operates by watching me in action it my classes. Trust me: It will be an eye-opener.

Bernie Madoff. Goldman Sachs.
Those two names don’t seem like they’d have a lot in common, do they?
Madoff is a despised figure, while Goldman Sachs is a revered firm on Wall Street. Madoff just received a 150-year jail sentence, while Goldman just recorded the biggest quarterly profit in its history as a public company.
So, what do they have in common, and what can you learn from them?
Most people don’t realize this, but Madoff made a large chunk of his money over the years not through his investments but by his market making activities. For those unfamiliar with market makers, these firms maintain a market in a particular stock by buying and selling shares in it, and filling orders accordingly. Madoff’s firm was known to traders under the symbol MADF.
So, Madoff accumulated much of his fortune through trading-related activities. Meanwhile, Goldman Sachs operates in a similar manner.
You might assume that a firm that won’t even considering taking you on as a client unless you have at least $5 million to invest would make most of its money through its investments.
But, you’d be wrong.
Roughly 70% of Goldman’s revenues comes from trading-related activities; namely, through its role as a market maker and through its trading desk.
The takeaway here is that there’s far more money to be made by trading, not investing. Why else would Maddoff and Goldman be so heavily involved with trading? This is particularly true during chaotic, tumultuous times like those that we’ve experienced over the past few years.
As a trader today, you have far more advanced tools at your disposal than you did years ago. The opportunities are there for you. It’s up to you to use them as wisely as possible, and get the most profits out of your trading.
Granted, successful trading isn’t easy. But, I can teach you how to do so.
As Maddoff and Goldman Sachs showed, there’s a ton of money to be made through trading. So, why not grab your little slice of the pie?

Things are not always what they seem on the Level II screen — professional traders constantly engage in sleight of hand to fool unwary traders. But there are a few signs you can look for to avoid becoming another victim — and you can profit from this information, too. 

The Level II quote display allows you to see beyond the nearest bid and ask prices of a Nasdaq stock to the entire list of bids and offers, including firm and size.  Although Level II (officially called the “TotalView” quote display) provides a great deal of market information, it can also be deceptive — especially for new traders who are unfamiliar with the sleight-of-hand practices of Nasdaq market makers. The market-maker “trap” is a mirage conjured by professional traders to entice you into buying or selling a stock precisely at the wrong moment. However, if you know what to look for, you can position yourself to take advantage of these setups rather than fall victim to them.  

TotalView: The LevelII quote display Figure 1 shows a Level II screen for Glenayre Technology (GEMS), along with a time and sales window (right), from May 10, 2005. The Level II window has two sides — the left shows bids and the right contains offers . The bid and offer columns list the market maker ID (MMID), price, and size for each order.

For example, the first entry on the bid list is “SIZE,” which means it is an order placed through the Nasdaq Market Center. The bid price is $2.65 and the order size is 5, which represents 500 shares. The next three listings are ARCA#, ISLD#, and BRUT#, which are the IDs for the Archipelago, Island, and Brut electronic communications networks (ECNs). Next listed is UBSS, which is the market maker UBS Securities. (Market makers also sometimes use ECNs to place trades without showing their ID.) The right side of the window lists the same information, except the orders are offers to sell.

The various price levels for bids and offers are delineated by different colors. On the offer side, some of the colored bands are “tall” — spanning several entries — indicating a large number of offers at the same price; the bid side has many colors, indicating a wide range of bids below the highest bid. When there are many colors, as is the case with the bids in Figure 1, the quote is said to be “rainbowed.” In the time and sales window, executed trades are colored green if someone pays the offered price or red if someone hits the bid.

Head Fakes: Marker maker traps When market makers want to buy shares, they try to create the illusion the market is about to go down so they can purchase at a low price. To accomplish this, they place offers very close to the last price while showing bids (if any) well below it. This leads uninformed traders to believe market makers are looking for lower prices — the so-called “head fake.” Although the Level II screen offers a detailed view of the market, market makers create misleading pictures of supply and demand to trick inexperienced traders. Novice traders will often sell out any long positions in such circumstances because they do not want to be caught long because of the size being offered. The novice may even attempt to “front-run” the market makers and go short — to get a jump on what they perceive to be an imminent downtrend . Let’s look at this scenario in detail. Figure 1  shows the last price was 2.65 and there are twelve market makers and ECNs offering shares between 2.66 and 2.69. On the other hand, there is only one market maker showing a bid at 2.65. There are two ECNs bidding 2.63, one ECN bidding 2.61, and two market markets bidding 2.57. The time is 10:18:57. Looking at this Level II screen, you might think the market is vulnerable to a drop.

If any of the traders on the offer side decide to hit the 2.65 bid, the market could trade down to 2.50 in a heartbeat. Figure 2, a daily chart GEMS, shows the stock was trading higher for the second consecutive day on May 10 and was trading just above its February highs. Traders could easily think the stock has run its course, given the number of offers appearing so close to the last trade in the Level II window. In addition, the time and sales window from Figure 1 shows the trades are being executed on the bid — that is, traders are selling into the bid. The last seven trades were at 2.65 — market makers are being hit at 2.65 and are “refreshing” their bids (i.e., they keep coming back). Still, to the untrained eye, it appears that there are plenty of shares for sale and traders are hitting bids. This is precisely what market makers want you to conclude — the basis of their trap. Figure 3 is the one-minute chart of the stock roughly three minutes later (around 10:21), and Figure 4 is the Level II window around the same time. Figure 1 was the Level II window at 10:18:57, at which point the stock had just been down to 2.56 and then recovered. Figure 3 shows that following the quick break, the price action immediately ran to a new high (2.72) for the day, despite all of the offers shown at 10:18:57.

Web-based trading vs. direct access and payment for order flow 

When hen you use a standard discount online broker, your order is often rerouted to another source for execution — your broker is essentially functioning as a “middle man.” You are essentially sending your brokerage an order via e-mail, and the brokerage executes the order in the way that offers it the greatest benefit. Many discount brokers rely on “payment for order flow” to generate income. This is part of their business model and is one of the reasons discount brokers can offer low rates, especially for market orders. As a way to attract orders from brokers, some exchanges or market-makers pay your broker for routing orders to them — perhaps a penny or more per share. Payment for order flow is one of the ways your broker’s firm can make money from executing your trade. The firm can also make money by “internalizing” your order — i.e., executing it within its own internal order book. Payment for order flow is discussed at the U.S. Securities and Exchange Commission’s (SEC) Web site (www.sec.gov/answers/payordf.htm).

Upon opening a new account and on an annual basis, firms must inform their customers in writing whether they receive payment for order flow and, if they do, a detailed description of the type of the payments. Firms must also disclose on trade confirmations whether they receive payment for order flow; customers can make written requests to find out the source and type of the payment for a particular transaction. To learn more about the basics of trade execution — including order routing, payment for order flow, and internalization — read “Trade Execution: What Every Investor Should Know” at www.sec.gov/answers/payordf.htm. By contrast, direct-access order routing is what its name implies: Instead of being sent to a middle man, your order is entered directly into the electronic marketplace for execution. If you choose to lift someone’s offer, you are instantly filled. Or, just like a market maker, you can place bids and offers, be in the queue and wait for someone to take the other side of your order.  Figure 4 shows there are more offers listed close to the last trade price (2.69), while the bid prices fall away quickly from last price. The colored bands highlight the trap. On the offer side, the colored bands are taller than the bid side, and the bid side is rainbowed. Two minutes later, as shown in Figure 5, the market has again made new highs, despite the number of offers displayed in Figure 4.

These examples illustrate how market makers will set up the appearance of more supply than demand so they can attempt to buy at lower prices — in anticipation of a rally. Finally, the ECNs cannot be ignored because the market makers use them as well. For example, a market maker may offer stock at one price in the Level II window using the company’s ID, and at the same time place a bid through the ECN Island with the goal of actually getting shares.

Bearish traps When market makers are expecting the market to go lower they use the same kind of trap to entice traders into buying. Figure 6 is a daily chart of eCOST.com (ECST) showing the stock had fallen to new lows in a downtrend that began in late 2004. Figure 7 shows the stock’s Level II window.  Although there appears to be plenty of buyers from 3.11 down to 3.00, this is simply an illusion created by market makers. The bid colors are tall while the offer side is rainbowed; the offers are tight up to 3.15, then start expanding in 5- and 10-cent increments. Finally, the time and sales window shows most trades are being executed on the offer (green prices). An inexperienced trader might look at this screen and think, “If the traders on the bid get impatient, they will start to lift offers and the stock could easily leap to 3.40 or higher.” This trader could believe the risk is around 10 cents while the potential reward is 30 to 40 cents. Or, traders who are already long from a higher price might decide there is no reason to take a loss at this point. They can see how deep the bid is, down to 3.00, and any buying will rally the stock, which could lead to more buying because the market is obviously oversold. Figure 8 is the Level II screen less than two minutes later. The bid is building. The last price is now 3.10 and some new bids have come in at 3.07.

The bid appears to be very deep and the offers are thin. The offer side of the market is rainbowed. The stock should rally. The time and sales window shows more trading on the offer side than the bid side. The trap is set. Figure 9 shows the market 13 minutes later. The last price is down to 3.07 and the offer is at 3.06. Still, to the untrained eye, the bid appears deep down to 3.00, and many novice traders will conclude that the stock could still rally. Figure 10 shows the market less than 13 minutes later. The stock has broken down through 3.00, the best bid is now 2.82, and the stock is offered at 2.86. Throughout this example, the trap was the illusion that a good bid for the stock was here for everyone to see, while the offers were thin. While traders appeared to be paying the offered price in the time and sales window, the offer was being refreshed. The false impression is that if the players decided to start paying up, the price could rally. This is exactly what the market makers need you to believe so they can unload their shares on you.

The world of illusion Although the Level II screen offers a detailed view of the market, market makers create misleading pictures of supply and demand to trick inexperienced traders. The Level II screen should be thought of as a tool that requires experience and skill to produce useful results. If you are looking to trade a stock from the long side, look for the trap that gives the appearance the market is for sale. In such situations, the market makers want to buy stock in anticipation of an up move, so you want to be on the same side. Similarly, short sellers and traders who are already long should watch for traps that make it look as if the market is strongly bid. The scenarios are set ups for declines. For most traders, taking advantage of the trap is best accomplished in stocks trading below $30. Also, it is not a strategy to attempt in “brand-name” stocks such as Cisco and Intel, which have the best traders in the world. The trap occurs in these stocks, but it happens very fast — too fast for less-experienced traders.