Christopher A. Tyler was an Equity Options Market Maker on the American & Pacific Exchanges from 1992 to 1999. He is currently trading off floor in his own proprietary account employing technical analysis and option strategies in his trade decisions. Christopher is a member of TradingMarkets.com.

Since the humble beginnings of the NYSE under a buttonwood tree, one group of individuals has consistently outperformed the rest of the investment community. These people are called Specialists on the floor of the NYSE. (On Nasdaq listed securities, they are called Market Makers, or Dealers, and perform the same functions but through an electronic network, rather than on a physical floor.) In this article, I will focus on the role of the NYSE Specialists, but one group is easily substituted for the other as far as job functionality is concerned.

The function of a NYSE Specialist is to provide depth and liquidity in the securities that he/she is assigned in times of imbalances in either supply or demand. The Specialist executes this activity in his/her capacity as a Dealer. In times that demand outstrips supply, the Specialist is obligated to sell either his/her firm’s (Limited Partnerships with financial ties to well-capitalized clearinghouses/ financial institutions are standard practice) existing inventory, or go short the stock. This process is most often done at prices higher than the current bid/ask spread.

The Specialist is negating the imbalance, but in doing so is assuming risk in his/her Dealer account, and therefore the acceptance of this risk is usually transacted at a market premium. The inverse of this process is when supply is greater than demand, and the Specialist must purchase or go long the stock and accumulate inventory until the imbalance is worked out. This particular sequence would likely result in the Specialist purchasing shares at prices lower than the current quoted market, and would likely continue until an equilibrium between buyers and sellers could be established.

The Specialist also operates as a Broker in his/her assigned stocks. When the Specialist is not participating as a Dealer for his/her firm’s trading account, his/her responsibility is to maintain a fair and orderly market as a Broker in the product being traded. As a Specialist, this is his/her first priority regardless of the capacity he is fulfilling (broker or dealer, or both) at that time. Making sure that a fair and orderly market exists, in his/her Broker capacity, requires that all competitive bids and offers in his trading book, and those represented by other Traders and Brokers in the trading crowd are executed according to price, size, and time.

The role that we as traders are concerned with is the Specialist's function as a Dealer. Seats on the NYSE are currently trading near record levels, with the last recorded sale at $2.5 million. In a market environment that has left many successful traders scratching their heads, or taking extended vacations, why is there a demand for seats on the floor of the exchange? I know that I could elicit many answers from the people buying up the seats in the first place, but most likely, an educated guess would point towards the fact that the floor community, where the Specialist reigns like royalty, is still making money.

As traders always looking for an edge, we have to continually look for what’s working in the market and discard any additional baggage, so to speak. Considering the fact that for brokers, the commission business has all but gone the way of the quarter slice of pizza, it’s not difficult to emphasize that if the Specialists as a group are still making money, it must be primarily a function of their activities as a Dealer.

The Question Remains

Is there a way to capitalize on the Specialist system's apparent edge? I believe the answer to be a resounding yes, but one must realize that in order to participate, you as a trader must first know yourself inside and out. Financial as well as mental constraints must be examined and acknowledged, before trading profitably alongside the “smart money.” There’s a saying on Wall Street: The market is an expensive place to find out who you are. As we start to unfold some of the inner workings of the Specialists’ trading edge I think these words of wisdom will definitely ring true.

So how is it that the Specialists or “smart money” always seems to land on two feet? Whether the markets are going up, or down, this group is able to weather the storm as well as any Captain riding out sometimes treacherous conditions.

First off, one must realize that the Specialist is in a unique position. As the primary marketplace for listed securities the NYSE Specialists probably has, on average, the best knowledge of what the overall supply/demand conditions are, at any given moment, in the stocks that he or she deals in. Is this infallible, no, but it’s definitely privileged information that comes with the responsibilities of being a Specialist. This information might be in the form of resting orders on the Specialist’s book, representing support and resistance levels away from the current price, or it could be from working with the trading crowd, and the order flow they represent. Either way, this is a legitimate edge that as a Dealer, the Specialist can take advantage of, by means of accumulating long or short positions based on supply and demand in the marketplace (of course this Dealer activity must abide by the rules of the NYSE).

The other edge, and equally important, if not more so is the Specialist’s role as the buyer or seller of last resort. This falls under the function of providing depth and liquidity in times of supply/demand imbalance. Under normal market conditions, in laymen’s terms, it allows the Specialist to buy on the bid, and sell on the offer, and thereby profiting from the spread. More importantly, to the trader wishing to unlock the “smart money” edge, is the fact that in times of high volatility it allows the Specialist to accumulate or distribute inventory at levels that would, under normal market conditions, be considered at a huge discount (accumulating) or premium (distribution) to fair market value.

But, what is fair value, other than what the market is willing to bear? In times of market panics, when fear or greed is running rampant, (by the way this happens in both directions, for those of you who don’t remember the Fall of ’99 into the Spring of 2000), when liquidity has vanished from the markets and the Specialists have little or no competition you can bet that “fair value” is at a huge discount. As the provider of last resort in times of high market volatility, the Specialists have the ability to accumulate positions at extreme price levels that are considered “fair value” temporarily, as other investors are more than willing to exit their positions for piece of mind.

Now consider the statistic that the Specialists on average, only participate in roughly 10% of NYSE volume (NYSE.com), and one can surmise that a Specialist in his function as a Dealer, really is the “smart money.” When one realizes the fact that dealer activity is limited to this percentage level, and the fact that this group of market professionals consistently makes money, it’s safe to assume that their accumulation and distribution of inventory happens at very advantageous price levels.

As traders, this means we would love to follow in the footsteps of NYSE Specialists. We might not have the same access to information or privileges that the Specialist has as a direct result of his job description, but fortunately without having to buy a seat on the Exchange, we can follow their activities as Dealers. As traders, we can make a very good educated guess about when the “smart money” is mounting a campaign of accumulation or distribution through price and volume charts (or statistics for the mathematically inclined) and sentiment indicators, such as the Connors VIX Reversal system.

The technology and access to the markets has changed over the years, thankfully for the active trader. What moves the markets, namely the constant cycle of fear and greed, the frailty of the human condition, fortunately has not changed. What this means for today’s technician is the ability to gauge market extremes better than ever, and pinpoint with better accuracy what the Specialist might be doing, thereby affording us the opportunity to trade alongside a consistent winner.

In Times Of Crisis

The tragic events of Sept. 11 will go down as a day of infamy. The social and economic repercussions were swift and severe, forever changing our country. The financial markets were a mirror image of the investment community’s anxiety and fear over the consequences and uncertain geopolitical future. Once again, fear ruled on Wall Street.

My intention here is not to downplay this tragedy, especially since, as a former member of the American Stock Exchange, it struck very close to home. The point is that amid the ensuing financial chaos, the Specialists in their capacity as providers of depth and liquidity, were able to ultimately profit handsomely from other investors' need to liquidate at whatever prices the “smart money” would bear as buyers of securities.

From a technical perspective, the price charts in conjunction with technical rules and sentiment indicators hinted strongly at which side would ultimately prevail. Of course, knowledge of the Specialist accumulating stock in of itself doesn’t necessarily help us as traders. The Specialist has much deeper pockets than most of us could ever fathom. During a campaign of accumulation this process does indeed use, and need this financial muscle. Otherwise, during the period of time that his campaigning is taking place (dollar cost averaging) this provider of last resort would become as helpless as those that he is profiting from.

Inevitably, as was the case during the week after the markets reopened, anyone who bought the day the markets reopened with the intention of turning a quick profit was most likely sadly mistaken. If a trader was applying money management principals he or she could have encountered many lumps in the form of stop losses before the eventual bottom, and reversal in the markets.

The Specialist in his capacity doesn’t have the luxury in times of crisis of stopping himself out with small losses, but instead needs to focus on being able to accumulate at levels that are attractive enough to withstand temporary punishment in the form of paper losses. With their financial and market acumen they are able to do this, but for us, just the knowledge of their accumulation is not enough. The “smart money’s" accumulation might be an excellent starting point for us, but for the trader to thrive and use this information effectively requires using a technician’s arsenal.

The above charts demonstrate how a trader could have effectively profited from knowledge of accumulation by the “smart money.”

The first chart is a four-year weekly of the VIX. The VIX represents equity option premium levels. The higher the VIX, the more fear that’s hanging over the market. The Connors VIX Reversal strategy takes advantage of this contrarian sentiment indicator, which is detailed in the Trading Markets indicator section, but for illustration purposes in this article we only need to recognize the fact that panic was definitely permeating the market.

The VIX hadn’t seen levels this extreme since the Fall of '98, coincidentally a prior market bottom. Now take a look at the chart of Tenet Healthcare (THC | Quote | Chart | News | PowerRating). THC had all the trappings of a strong market performer prior to the events of 9/11. Tenet was in a strong up trend from the last week of May (the longer-term trend began in July 2000), and had just made fresh 52-week highs two days earlier.

With the events of Sept.11, along with any group that wasn’t related to a wartime economy, THC, which had clearly been a strong RS stock, was taken down approximately 12 % during the next few trading sessions. The up trend line was broken, but the astute market technician reacting to the extreme VIX readings and the technical picture of THC would have been alerted to a great opportunity on the buy side.

On 9/21 THC made a perfect double bottom test of the August low at 52.5, which also lined up within .50 of a 38% Fibonacci Retracement (a tad bit over). THC went on to score a 20% gain during the next month as the markets rallied off their September lows. I quoted an old Wall St. adage earlier, about how the markets can be a very expensive place to find out who you are. I’ll add to that now by saying, “If you know who the Specialist is, and you know yourself as well, Wall Street can be a very nice street indeed.”