The Role of the NYSE Specialist

What exactly does a specialist on the New York Stock Exchange trading floor do? Many traders think that the specialist is some sort of parasite that takes a cut out of everyone else’s profits. But that is not really correct.

The specialist is required by exchange rules to continuously post both a bid and an offer in the stocks they are responsible for making a market in. If there are no bids or offers from the public, then the specialist must risk his own capital and buy or sell shares in order to execute the orders sent to him.

For example, say that XYZ most recently traded at $25.10 a share. Let’s say that XYZ is a thinly traded stock and that the highest bid from a public trader / investor to buy stock is $24.25 and the lowest offer to sell stock is currently $26.30 a share. By NYSE rules this is too wide a market, so the specialist would be required by the exchange to post a better bid and offer using his own capital. He might bid $24.90 to buy stock and offer to sell shares at $25.30 a share.

Given this bid / offer quote the specialist could buy stock at $24.90 and sell it at $25.30 all day, and put $0.40 a share in his pocket. If he traded 30,000 shares this way he would make $12,000 for his trouble. So he’s a leech right? Wrong. If he was not in the market, the buyers that he sold stock to would have paid $26.30 instead of $25.30 a share. On 30,000 shares, the buyers would have paid an extra $30,000 for their stock. The sellers of XYZ would have also gotten significantly less for the shares they sold.

The specialist is also required to provide a “fair and orderly market” under difficult circumstances. I saw many examples of this more than 30 years ago when I was a specialist clerk. Back in those days the first computer link with the NYSE floor was being tested on a small number of stocks and total exchange volume of 20 million shares in a day was considered very heavy trading. Corning Glassworks (now Corning Inc., symbol GLW) was a very thinly traded stock, with only a couple thousand shares trading per day. There were virtually no public orders in the stock. The specialist was the market.

One morning a Saloman Brothers broker came to the Corning specialist just before the opening, looking to sell 200,000 shares of stock. This was more than 10 times the normal daily volume of the stock. Without batting an eye, the specialist agreed to buy all 200,000 shares, using his own money, two dollars below yesterday’s close (somewhere around $75). The specialist now had about $15million dollars of his own money at risk.

As soon as the trade hit the tape buyers, seeing a chance to buy the stock $2 lower than yesterday, came pouring in. Since there were no public orders in the specialist’s order book, the specialist was the only seller. He made a huge profit that day, as the stock closed about where it had closed the day before.

Some would say that the specialist took advantage of his position to profit. But where would Saloman have sold 200,000 shares for their client if the Corning specialist had not bought it? Down $10 or $20 points most likely. Is the seller complaining about the specialist profiting? How about the buyers who bought shares from the specialist at prices lower than yesterday’s closing price, are they complaining? It seems to me that everyone was a winner on this trade, thanks to the specialist taking a huge, but profitable, risk.