Introduction 3. How Securities Are Traded The McGraw−Hill Companies, 2001           78 PART I Introduction     Part of the specialists job as a broker is simply clerical. The specialist maintains a "book" listing all outstanding unexecuted limit orders entered by brokers on behalf of clients. (Actually, the book is now a computer console.) When limit orders can be executed at market prices, the specialist executes, or "crosses," the trade. The specialist is required to use the highest outstanding offered purchase price and low- est outstanding offered selling price when matching trades. Therefore, the specialist system results in an auction market, meaning all buy and all sell orders come to one location, and the best orders "win" the trades. In this role, the specialist acts merely as a facilitator. The more interesting function of the specialist is to maintain a "fair and orderly market" by acting as a dealer in the stock. In return for the exclusive right to make the market in a specific stock on the exchange, the specialist is required to maintain an orderly market by buying and selling shares from inventory. Specialists maintain their own portfolios of stock and quote bid and asked prices at which they are obligated to meet at least a limited amount of market orders. If market buy orders come in, specialists must sell shares from their own accounts at the asked price; if sell orders come in, they must stand willing to buy at the listed bid price.3 Ordinarily, however, in an active market specialists can cross buy and sell orders with- out their own direct participation. That is, the specialists own inventory of securities need not be the primary means of order execution. Occasionally, however, the specialists bid and asked prices will be better than those offered by any other market participant. There- fore, at any point the effective asked price in the market is the lower of either the special- ists asked price or the lowest of the unfilled limit-sell orders. Similarly, the effective bid price is the highest of unfilled limit-buy orders or the specialists bid. These procedures en- sure that the specialist provides liquidity to the market. In practice, specialists participate in approximately one-quarter of trading volume on the NYSE. By standing ready to trade at quoted bid and asked prices, the specialist is exposed somewhat to exploitation by other traders. Large traders with ready access to late-breaking news will trade with specialists only if the specialists quoted prices are temporarily out of line with assessments of value based on that information. Specialists who cannot match the information resources of large traders will be at a disadvantage when their quoted prices of- fer profit opportunities to more informed traders. You might wonder why specialists do not protect their interests by setting a low bid price and a high asked price. A specialist using that strategy would not suffer losses by maintaining a too-low asked price or a too-high bid price in a period of