The 1990s was the wild west for day trading. Today we’re going to look back into trading history at a group of traders known as the SOES Bandits and see what we can learn from them.
The SOES (small order execution system) was a system created by the NASDAQ in 1984 for the benefit of retail investors. Essentially, the system would allow you to route orders of 1,000 shares or less for immediate execution, placed first in the queue, as long as the orders matched the market makers’ quoted price.
Initially, the system was rolled out on a limited number of low volume, small capitalization stocks that market makers tended to ignore, allowing retail traders to facilitate trade without waiting all day to get filled on their order.
After Black Monday, the SOES system was instituted for most NASDAQ securities due to market makers and brokers not answering the phone to their smaller clients during the event, preventing retail investors from getting out of the market.
This system was quickly exploited by a group of traders known as SOES bandits, who were soon responsible for 13% of Nasdaq volume. Their main advantage was speed. Bandits were trading electronically and receiving instant executions while their counterparties were analog, in a trading pit.
They quickly became vilified by Wall Street, regulators, and the financial media.
A Primer on SOES (Small Order Execution System)
At first implementation, the SOES was a win-win for market makers and retail traders. Retail traders could buy or sell small caps quickly, and market makers didn’t have to worry about making markets for low volume small caps.
The inefficiency present in the market became really apparent post-Black Monday, when SOES was rolled out on all Nasdaq securities. SOES bandits would wait for news or momentum to come into a stock and try to catch the market makers sleeping–try to snipe their posted quotes before they can update them to reflect the new prices.
SOES banditry was all about interacting with fragmented order flow. The bandits’ speed advantage was mostly responsible for their edge. While market makers were doing business in a trading pit and talking on the phone, a bandit can get in and out of a stock with the click of a button.
The mandortization of SOES across the NASDAQ was met with hefty objections by market makers, claiming they were being taken advantage of by day traders. In a study of SOES trading profits, Harris and Schultz found that bandits only profited when they entered the market through the SOES and exited through a route like SelectNet or Instinet, usually used by institutional investors, so market makers weren’t the only counterparties.
The Start of High Frequency Trading and Automation
SOES banditry was arguably the first form of high frequency trading. As the technique developed from point-and-click trading, where those who typed orders the fastest got the best fills, to the development of technology to automate the process, the trading frequency became quite high.
The first big breakthrough for high-frequency SOES traders was the development of trading software Watcher, made specifically for SOES bandits.
Only providing level 1 and 2 quotes and allowing direct order routing, the software was archaic by today’s standards, but gave 1990s day traders a significant edge.
Above is an example of a quote generated by Watcher for the stock GEKA. The top line displayed the ticker, bid and ask, and how many market makers one each side of the market. The second line displayed the daily high and low, the net change since yesterday’s close, and the stock tier (SM5 in this case, meaning the max order size was 500 shares). The ensuing lines are the level 2 market depth. There is an asterisk next to the most recently updated quote. In the above case, it’s COWN.
I can’t find any images of Watcher online, but I was able to find the users manual online here. It’s pretty cool to read!
The software didn’t do much more than that, save for news and position management window. I think this gives us modern traders some perspective. In an era of markets so focused on new technology and analytics, it can feel like if our setup doesn’t look like the image below, we’re not taking in enough data. The SOES bandits knew they had an edge and only took in the information required to play out that edge. No technology or data is a substitute for a definable trading edge.
J.H. Harris and P.H. Schultz were given access to the trading records of two SOES-focused prop firms for their study of the trading profits of SOES trading. One firm, referred to as ‘firm A,’ was responsible for between 0.5% and 0.7% of Nasdaq volume, and they weren’t even the largest SOES trading firm.
On the whole, the two prop firms Harris and Schultz studied had a significant edge, with firm A only losing 35% of their trades, and firm B losing 30% of the time. Their winners were also larger than their losing trades.
Below is a diagram of the average profit of each trade:
The original traders who were on the forefront of SOES trading play a huge role in the development of modern market structure and the democratization of markets for the retail player. After all, the SOES was originally an innovation by the NASDAQ for the benefit of the retail trader.
Harvey Houtkin, a founder of both All-Tech Investment Group and Datek Securities, is credited as being the original SOES bandit. At one point, All-Tech was executing as much as 25% of the SOES’ volume. Houtkin penned several trading books, the most notable being Secrets of the SOES Bandit.
The New York Post has even given Houtkin credit for the NYSE and NASDAQ’s yet-to-happen IPOs in 1999: “So, when the NYSE has its IPO, just remember it was some crazy kid from Sheepshead Bay who made it all happen.” Houtkin passed away in 2008 and was remembered by the Wall Street Journal as the “father of day trading.”
Beyond Houtkin, most SOES bandits were concentrated in a few prop firms that specialized in SOES trading.
Here’s a short list of notable SOES-focused prop trading firms:
- Datek Securities
- All-Tech Investment Group
- A.B. Watley
- Momentum Securities
- Dina Securities
SOES Banditry Lead To More Efficient Markets
SOES bandits were blamed by Wall Street, the financial media and regulators for reducing liquidity, widening spreads, and increasing market volatility. With bandits being short-term momentum traders, buying as prices are rising and selling as prices are falling, there was a general anxiety that SOES traders were falsely contributing to ‘fake’ market trends that weren’t based on real fundamental factors.
Harris and Schultz found almost the opposite to be true. They found that instead of increasing market volatility, they instead concentrated price changes into shorter time periods. Instead of a micro market trend taking an hour to unfold, it might have taken 15 minutes with bandits trading behind it. They made prices adjust faster, most would consider that increased market efficiency.
The paper also discovered an agency problem in trading. Because market makers weren’t trading their own accounts, they weren’t strongly incentivized to create price discovery in the way a bandit, trading their own account, was.
“Thus, bandits have much greater incentive to concentrate on what they are doing, to follow stock prices closely, and to stay in front of their terminals than do market-maker employees… The importance of these agency costs for market-making implies that individuals, trading their own accounts, may provide more efficient and more competitive market-making services than market-making firms that rely on employees to trade for them.”
In the same way that high-frequency trading is responsible for tighter spreads and increased liquidity (when there’s not a flash crash), SOES banditry had similar effects on market structure. Of course, there’s always a losing counter party. With HFT, most traders are paying a small spread, and market makers were sometimes getting their lagging quotes sniped. In the big picture, though, trading costs are driven down.
SOES trading also benefited retail traders far more than institutional investors. Harvey Houtkin recalls his experience trying to trade with market makers before the SOES was widely implemented:
“I couldn’t even get a simple 500 share trade off…Market makers wouldn’t answer their phones, they would hang up on you, curse at you. I was seeing it from the other side, and I got frustrated because the whole thing was so corrupt, the market makers were such thieves.
Taking Advantage of Inefficiencies
While there is significant evidence that there was a skill spectrum among SOES bandits, and that they did exhibit skill in forecasting short term price changes, their main edge came from their structural advantage.
They were taking advantage of fragmented order flow. Using Watcher, bandits identified the stocks in which several market makers were updating their quotes at once. That would tick them off that there was momentum building in that stock, and they’d try to get filled by taking liquidity from market makers who haven’t updated their quotes yet.
Market structure has changed. Virtually all trading is done electronically. There used to be several specialists on the trading floor making markets. Now, market making is mostly concentrated in a few designated market making firms, all of which who make markets with assistance from automation. This eliminates the ability for a hand trader to take advantage of any lagging quotes.
Good trading takes creative thinking. While the SOES was an obvious thing to take advantage, sometimes it takes some digging. Inefficiencies in the modern market are going to be very hidden and unscalable: aka Virtu or Citadel can’t arbitrage them away because there’s not enough money in it to make a difference in their bottom line.
A good example of an unscalable and hidden edge is Peter To’s 8AM ARCA Low-Offer.
We will never see an inefficiency so widespread like the SOES ever again. There is too much institutional money chasing those edges that they are whittled away rapidly. However, there are several international markets with less liquidity, where institutions would be unable to scale their strategies, but an individual would.
The US markets have become quite democratized. Virtually all trading is electronic, and outside sub-pennies and milliseconds, nobody has a structural advantage the way SOES bandits did. You have to identify a market with fragmented order flow. In other words, a situation where there is a massive structural disadvantage to the counter party. This could be the difference between analog and digital, like the bandits and market makers, or something else.
It’s easier said than done, but I know I haven’t seen all the stock exchanges the world has to offer, and I’d bet that most traders haven’t either. There is likely some huge, unscalable inefficiencies large enough to make one, or a few people rich out there.
Even within the US market, there are still plenty of individual traders finding inefficiencies to take advantage of. This brings me back to a quote I cite often from Jack Schwager: “There are a million ways to make money in the markets. The irony is that they are all very difficult to find.”