We Asked A Market Structure Expert To Change One Rule About The Stock Market

Tim Quast is the founder and CEO of ModernIR and Market Structure Edge, an analytics platform that provides signals using market structure. 

Quast has previously testified in front of the House Financial Services Committee about issues relating to market structure, such as Regulation National Market system and payment for order flow. 

Benzinga asked him if he could change one rule about how the stock market works, what would it be. 

His answer: the order protection rule. 

What Is The Order Protection Rule

The Order Protection Rule is part of a landmark regulatory change by the SEC that went into effect in 2007 called Regulation National Market System— or Reg NMS. 

The rule states that exchanges and other trading venues must publicly share their best quoted price for a given security, and that investors in that security must have their order executed at that best price or better. The rule was enacted to prevent what is known as trade throughs, where orders are passed to other venues and executed at sub-optimal prices. 

“The order protection rule has altruistic intent,” said Quast. “It says that you cannot trade at a price different from the best price in the marketplace. For instance, if Microsoft Corporation MSFT is trading at $210 at the NYSE, I cannot go buy it for $209 at the Nasdaq. It's against the law.”

The Problem With The Rule

One of the implications of the OPR rule is it forced the markets to become more interconnected. This has its benefits, but according to Quast also resulted in some unintended consequences. Namely that it allows every trade to be gained by somebody else. 

“If I'm forced to trade at the best national price, some machine is always going to be ahead of me changing the price. So if I want to buy 500 shares, it's going to keep moving the price away from me because I have no choice.” So I have long proposed to the SEC that they get rid of that rule. If you've got rid of that rule and disconnected the markets, I would do that too so that they can compete with each other legitimately.

“If the NYSE is a better market than the Nasdaq, that should stand on its own two feet. They shouldn't be forced by rules to share prices and customers. If I could buy Microsoft at the price I'd want, that seems fare. If I'm willing to buy 500,000 shares at $209, if somebody else wants 100 shares and is willing to pay $210, that's their business. I think that that's how free markets work, but our market doesn't work that way.”

Using Market Structure To Your Advantage

The fractured-yet-connected nature of our markets has created inefficiencies that Quast says can be mined for clues. Specifically, these clues can come from three areas: what kind of behavior is responsible for a given trade (active investing, passive investing, high-frequency trading, etc), the amount of volume coming from shares sold short, and market structure sentiment. 

These clues, he says, can help you understand the supply and demand dynamics of the market. 

“The struggle with fundamental analysis is the immense number of factors. You're always going to get beat by a quantitative firm that can do all sorts of Monte Carlos and regression analysis on five hundred different financial factors. And yet you can level the playing field with somebody like that by simply using market structure. 

“By using those factors, you can avoid risk and take advantage of entry points. And it's got nothing to do with whether Tesla Motors TSLA is going to be a globe-beating enterprise or not. It has purely to do with how the stock is traded every day.”

Tim Quast will be discussing how to gain a trading edge using market structure sentiment at the next Benzinga Boot Camp, Friday, August 28 at 12:00 pm ET. Click here to register and reserve your spot. To learn more about Market StructureEDGE and sign up for a free two-week trial click here.