Recent changes in SEC regulations and technology have transformed how investors interact with the stock market. I explain these changes in the following sections, and I show you how these changes enable online investors to make more money on their investments. In the following sections, you gain an understanding of what happens after you click your mouse button to execute an online trade. You also discover how you can avoid hidden transaction costs by using an electronic communications network (ECN) and how you benefit from ECNs even if you never use one.

How ECNs work In 1988, the Securities and Exchange Commission (SEC) began requiring NASDAQ market makers to accept buy and sell orders of up to 1,000 shares via an automated small-order execution system (SOES). This requirement opened the door for the so-called “SOES bandits,” who later became known as day traders. It also led to the development of the first electronic communications networks (ECNs), and in January 1997, the SEC approved the first four ECNs. Today, nine ECNs exist.

Stocks are traded by specialists on the New York Stock Exchange (NYSE) and by market makers in the NASDAQ market. For example, the NASDAQ requires at least two market makers for each listed stock. This requirement creates a market in which the stock is bought and sold. On ECNs, computers replace specialists and market makers. Anyone can purchase NASDAQ-traded equities through a brokerage that uses an ECN. Investors buy stock through an online broker, and if the broker’s computer finds a seller in an ECN, the investor’s order is executed with no human intervention. (And because computers never sleep, ECNs open the way for after-hours trading.) To gain some insight into how ECNs work, compare how investors purchase equities on the NYSE, NASDAQ, and ECNs. Buying stock on the NYSE involves the following steps:

1. The broker sends a buy order to a specialist on the exchange floor.

2. The specialist looks for sellers on the trading floor or in an electronic order book.

3. If the specialist finds enough sellers to match the offer price, the specialist completes the transaction.

Here are the steps for buying stock on the NASDAQ:

1. The broker consults a trading screen that lists how many shares various market makers are offering to sell and at what price.

2. The broker picks the best price and sends an electronic message to the market maker, who must sell the shares.

In contrast, buying stock on an ECN involves these steps:

1. The broker sends a buy order to an ECN.

2. The computer looks for matching sell orders on the ECN.

3. If the computer finds enough sellers to complete the trade, the transaction is executed. Otherwise, the order isn’t executed.

Understanding inside spreads One of the first steps in understanding trading is to define the players. What day traders really focus on are the activities of market makers. A market maker represents an institution (such as Lehman Brothers, Merrill Lynch & Co., Prudential Securities, and so on) that wants to make a market in a particular NASDAQ stock. The market maker is a specialist on an exchange or a dealer in the over-the-counter market who buys and sells stocks, creating an inventory for temporary holding. The market maker provides liquidity by buying and selling at any time. However, the market maker isn’t under any obligation to buy or sell at a price other than the published bid and ask prices.

The downside of being a market maker is that you’re obligated to purchase stocks when no one wants them. The upside of being a market maker is that you get to pocket the profits of a spread. A spread is the difference between a bid and ask price. For example, a stock with a bid and ask price of 15 × 151⁄4 has a spread of 1⁄4. The bid price is $15, and the sell price is $15.25. By selling 1,000 shares at $15.25, the market maker profits by $250.

Spreads are often just a few cents for each stock. However, these pennies quickly become dollars because of high trading volume. Last year, NASDAQ market makers earned $2 billion from spreads. Day traders have sliced into some of these profits. Recent reports indicate that market maker spreads are down by 30 percent.

The existence of several kinds of spreads has caused some confusion. The following list defines some of these spreads:

Dealer spread: The quote of the individual market maker. A market maker never earns the entire spread. The market maker needs to be competitive on either the bid or offer side of the market. The dealer is unlikely to be at the best price (the highest price if selling and the lowest price if buying) on both sides of the market at the same time.

Inside spread: The highest bid and lowest offer being quoted among all the market makers competing in a stock. Because the quote is a combined quote, it’s narrower than an individual dealer quote.

Actual spreads paid: The narrowest measure of a spread, because it’s based on actual trade prices. The actual spread paid is calculated by measuring actual trade prices against the inside quotes at the time of the trade.