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The Late Charge


Several Minyans have asked why the market seems to rally into the close of trading almost every day. The story is a rather long one (but I will try to make it short) and it (surprise) has to do with brokers making money.

In the 80's and 90's broker-dealers were paid anywhere from 10 cents to 15 cents a share to execute stocks. At those commission levels it made economic sense for them to run a capital intensive business called "block trading" where they provided liquidity on large orders. For example, a large buy order if brought straight to the floor would have difficulty getting done in a short period of time and may simply result in driving the stock price up with only a small execution for the customer. So the broker would "facilitate' the trade: sell the stock to the buyer and put the short stock into inventory. Over time "real" sellers (other large institutions as opposed to floor traders or specialists) would want to sell the stock and the inventory would be liquidated. Over many stocks and over much time at these commission levels both sides were served: the institutions were able to complete orders and the broker-dealers made money.

Enter the consultants. Over many studies they determined that the investors in the funds were not being served by the high commission rates. The great push (this is even before the advent of high technology) for lower commission rates was on. As rates dropped first to 5 cents and then even lower it no longer made economic sense for broker-dealers to commit capital to facilitate trades. The funds paid lower commissions, but had greater and greater difficulty in executing trades: what they saved in commissions was more than offset in execution cost (price paid).

A further step was developed as an attempt by both sides to improve the process: the program trade. This involves grouping together many executions and having the broker-dealer execute the "program" over the course of the day. Because of the great many shares in these programs, the broker, it was felt, would become more aggressive on commission and execution. A methodology was developed as the benchmark called Value Weighted Average Price or "VWAP". The theory was that the best execution would be realized if these large orders were diluted over the course of the day: the fund would realize better liquidity and at the same time pay less in commissions.

The broker is paid a nominal commission of 1 to 2 cents per share and then encouraged to spread the orders out over the course of the day by splitting (usually 40% to the broker) any improvement over the trade weighted average price of the day with the investor. For example, if at the end of the day the trade weighted price (take each price times the volume at that price divided by the shares traded that day) was $50 and the execution price was $49.75, the customer will pay the broker dealer an extra 10 cents a share ($.25 x 40%).

It is obvious that the broker dealer is greatly incented to beat the VWAP and they have figured out how to maximize this. When they get a large order, especially one where the amount is larger than a good percentage of the average daily volume (this allows them to control price), they buy a little in the morning and throughout the day, but save a good portion of the trade for the end. This statistically gives them the best chance of driving up the price of the stock at high volume, creating a higher VWAP than would otherwise be the case: the higher the VWAP, the greater the chance for the spread over actual execution.

When money is coming into the market, most if not all of these VWAP programs are buy programs. This is why you see buying in the morning, then a stall, and then buying into the close. There is no outfoxing the fox.

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