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Shares: How to trade Aim stocks

Created:
28 April 2006
Written by:
Simon Thompson

Until recently, all aim stocks used to trade on the London Stock Exchange's (LSE) competing quote-driven platform, SEAQ. Every market maker in a particular stock would post a two-way price, revealing the price at which it would buy or sell for a specified number of shares.

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But many investors complained about the wide bid-offer spreads (the difference between the buying and selling prices) for smaller companies. It made trading expensive, which hampered liquidity, and ultimately made small-caps less appealing.

So the LSE's answer has been to extend to small-caps the kind of electronic trading that revolutionised dealing in blue-chip stocks when it began in 1997.

Dealing through SETSmm

On 5 December 2005, the LSE kicked off the process with 60 Aim stocks (members of the Aim 50 index plus 10 reserves). They became tradeable on a platform called SETSmm, a hybrid that combines electronic trading with embedded quotes from market makers who provide additional liquidity.

And now some 93 Aim stocks now trade on SETSmm as the LSE continues its policy of adding newly eligible stocks as the result of index reviews, but leaving old stocks on the SETSmm platform.

The LSE points out that, since the move to electronic trading, the value traded by institutional investors has increased by 25 per cent, helped by the increased transparency and ability to participate in the price formation process. Average daily value traded is up by 26 per cent, and transaction costs (the difference between the mid and execution price) have fallen by up to 46 per cent for people trading modest amounts of Aim 50 shares.

To get the most out of this new way of trading, though, you really need direct market access (DMA). A number of brokers, such as iDealing, now offer direct access, giving you the ability to place trades on the SETSmm order book, while at least four contract for difference (CFD) providers - GNI, E Trade, Global Trader and IG Markets - offer synthetic direct access via CFDs.

So, for example, if you tried to trade the Aim stock Sportingbet (SBT) via a DMA platform, the screen (below) is what you might see.

Note the 'yellow' strip, which extracts the best bid and offer from the full list of buy and sell orders. This suggests that the best buying and selling price is 427.5p-427.75p. And note how you can get a feel for the liquidity, too. If you wanted to sell 10,000 shares, you could get most transactions executed between 427.5p and 427p, but would have to accept prices as low as 425.25p to complete the order.

You can see some of the competing market makers in this stock, with Citigroup (CITI) bidding 425p for 12,011 shares, and Arbuthnot (ARBT) bidding 424.75p for 18,750 shares. If you used a broker that provided DMA, you could submit a limit order to buy, say, 5,000 shares at 426p, and the order would appear on the left just above the order to buy 10,294 shares at 425.25p.

Of course, this does not guarantee execution unless your order is matched (the price drifts down and someone submits an order to sell at 426p), but it does mean that you can participate in the marketplace and make the bid-offer spread work for you, rather than against you. In effect, you can become a price maker, rather than a price taker.

Dealing in SEAQ stocks

However, most Aim stocks still trade on the Stock Exchange Automated Quotations platform (SEAQ), consisting of a quote-driven competing market-maker system. So also shown (below) is a typical screen shot for a SEAQ stock, in this case Penna Consulting (PNA), taken on the 6 April 2005. Although Penna is not an Aim stock, the same money-saving principles apply.

As can be seen, the yellow strip again extracts the most competitive bids and offers from the three competing market makers: ABN Amro (ABNV), Bridgewell Securities (BGWL) and Winterflood (WINS). The highest anyone is prepared to pay is 112p (Bridgewell), and the lowest any of them is prepared to sell at is 117p (ABN Amro and Winterflood).

So the spread is 5p, or a whopping 4.4 per cent. Add in 0.5 per cent stamp duty, and the round trip costs of buying and selling Penna are nearly 5 per cent. That sort of commission leaves much less room for error - and profit - when trading.

In this example, I wanted to buy 7,000 shares in Penna, but not at those prices. What could I do?

First, when dealing in SEAQ stocks, I always take screen prices as a starting point - regard screen prices as 'tourist prices'. But unlike an airport foreign currency booth, you can negotiate.

A quick look at Penna's price chart showed me that the stock had been under pressure for a number of weeks. I fancied my chances of picking it up for a bit cheaper than the indicated level of 117p. As can be seen from the screen, the market makers' quotes were good for either 2,000 or 2,500 shares, although the normal market size (NMS) for this stock is only 500 shares.

The key, here, is to use the telephone. Some execution-only brokers will trade on the telephone, although they may not advertise the fact. Pick up the phone and ask your broker to approach the market on your behalf. There are a number of different ways you could play it. These are a few suggested approaches, which can work in all stocks quoted on SEAQ, not just Aim stocks:

■ Ask your broker to approach the market, and ask for a two-way price in the size you are trying to deal in - here, it's 7,000 shares. Depending on whether the market maker reads you as a buyer or seller, the two-way risk price may suit but, by not opening first, you risk a less competitive price.

■ Give your broker a limit price. Tell him: "I want to buy 7,000 shares in Penna Consulting at 115p or better, take it or leave it." He goes round the market and bids all three market makers in turn. Your broker may come back with a counter-proposal from a market maker."Half to leave half" - this is more appropriate for a bigger order. Here, you agree to deal in half the number of shares (3,500) at the price that the market maker offers, and on the condition that you leave the balance of the order with him. This allows him the chance to find matching liquidity without taking the whole position on risk.

■ Leave an order with a market maker but, crucially, always leave a time limit. So, ask you broker to leave a designated market maker an order to buy shares at 115p until noon, and then to call back with an update.

■ 'Swap limits'. If the stock is 112p-117p on the screen, you ask your broker to buy 7,000 shares at 115p, and as before he bids the market makers for stock. But if the cheapest offer he can get is 116p, you may offer to 'swap limits'. By swapping limits, you can leave the order with the market maker at 115p, and if the stocks moves down he has the right to fill you at 115p, but if it moves up you have the right to buy stock from him at 116p. Swapping limits is an underused facility that not all market makers will agree to, and there is often some flexibility in the arrangement which will depend on a good relationship between market maker and broker.

Remember, also, that different stocks will have varying levels of liquidity, so 20,000 shares in one stock may be a large order, whereas in another stock it may be a small order.

On the day that I tried to buy Penna, I had no joy approaching the two market makers on the offer so I asked my broker to call the market maker showing the best bid - Bridgewell at 112p. I instructed my broker to approach Bridgewell, and bid 115p for 7,000 shares.

In some ways, going to the market maker showing the most competitive bid for stock and least competitive offer for stock may seem counterintuitive. Ordinarily, that might suggest a market maker who is keener to buy than to sell. But it can often be the case that the screen price is not representative of the true market in the stock. Sure enough, two minutes later my broker called me back with 7,000 shares bought at 115p on my behalf. In all likelihood, the market maker had stock on his book and was happy to move some, and had been on the bid to make the stock look a better market than it was. After all, he is only obliged to buy 2,500 shares if challenged (as shown on the screen), before having to move his price downwards.

In fact, there are all kinds of reasons why a market maker may influence a screen price while not revealing his true position. He may be working a large sell order for a client and so seek to hold the stock up to make it look a better market than it is and to make the price at which he is offering stock verbally to the market through his sales traders look attractive compared with the screen price. Similarly, if he is trying to buy stock, he may sit on the offer to hold the price down.

This market maker's screen franchise in SEAQ stocks means that screen prices should only be a guide to trading prices. In a quote-driven system, screen quotes are what a market maker thinks the price should be, and other market participants are unable to access the screen to show what orders they have. An order-driven system, although likely to lead to more volatility in price action, represents actual orders and trades.

Dealing through Plus Markets

Not everyone is convinced that electronic trading is appropriate for smaller-cap stocks, though, as liquidity can be thin. Some market makers think that there is merit to the quote-driven system. Plus Markets Group owns and operates an independent equity market in the UK with five active market makers: Cenkos Securities, Hoodless Brennan, KBC Peel Hunt, Teather & Greenwood and Winterflood.

Its quote-driven trading platform currently trades more than 750 small and mid-cap companies. Plus supports Ofex shares on its platform and, as of March this year, it has six Aim companies quoted: Croma, Dewhurst, Mears, Red Rock Resources, Regency Mines and Reliance Security Group. You also need to use one of the brokers registered with Plus to trade on its platform. Further details can be found at http://www.plus-trading.co.uk.

It will certainly be interesting to see if Plus manages to attract sufficient liquidity to achieve critical mass - so long as the bull market continues, it may well do so.

Using Retail Service Providers

The retail service provider (RSP) network was set up as a way of automating smaller trades between broker and market maker, obviating the need for manual intervention. And brokers are still keen on the system as it is cheaper and low maintenance, and allows brokers to submit orders automatically. Retail brokers don't make extensive use of SETS, which can only be used for trades for standard settlement anyway.

The RSP system polls the market makers that the broker is connected to and selects the best bid or offer. Typically, if a stock is showing 120p-123p, you might get a bid of 120.23p and an offer of 122.72p. This brings the bid-offer spread down to, say, 2.2 per cent from 2.5 per cent, with the certainty of dealing.

In this way, RSPs, or 'price improvers' as they are known, offer instant dealing with the gratification of a nominal improvement on screen price. So they are ideal for those investors wishing to deal quickly and in small sizes. More sophisticated active investors and traders will require a DMA service, though, which is what the institutions already use.

For more on trading Aim stocks on SETSmm, see:http://www.londonstockexchange.co.uk/en-gb/products/membershiptrading/tradingservices/setsmm.htm.

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