spread is often so high that it can completely nullify the theoretical advantage you get from buying small companies in the first place.

Here are some examples of how spreads affect prices in the real world.

First, as a general rule:

RULE 38

Small-company trading (e.g. Nasdaq): Dont trade thin issues with large spreads unless you are almost certain you have a big winner.

If the spread on a thinly traded stock is $2.50 to $3.50, for example, and remains constant when you go to sell, the issue will have to rise 40% before you can break even. With peanut-sized stocks this is precisely the type of spread you can be looking at. Anyone paying 30% or 40% every time he trades his portfoho is hardly likely to end up with the 925 times the amount invested (over 50 years) that some academics crowed about earlier. With charges Uke these, he (or his estate) would be lucky to come out with his skin.

Nasdaq, where most small companies trade, is a tough market not only for the average investor but for professionals as well. Its conraier-cials on national TV a few years back asked, "Where do you go to find the next Microsoft?" The answer boomed: "Nasdaq, the stock market for the next 100 years." Nasdaq sells glamour and the opportunity to hit it big. Of course, the commercial doesnt remind you that for every Microsoft among midget issues, there are dozens and dozens of busts.

Behind the smooth pitch is a market consisting of about 5 computer-linked, over-the-counter dealers, including the majority of the countrys largest brokerage firms, that trade in unhsted stocks." The name of the game, until the Securities and Exchange Commission (SEC) recently stepped in, was to keep the spreads as wide as possible. An array of academic and regulatory studies have concluded that Nasdaq dealers have kept their spreads unnecessarily wide for years, skimming huge profits on securities trades at the expense of the investor. Researchers estimate that investors lose a cool $2 billion a year between the price at which dealers will buy stocks and the price at which they will sell.

According to Arthur Levitt, the head of the SEC and former chairman of the American Stock Exchange, "We found a singular lack of competition on Nasdaq. Where there are few incentives for dealers to compete

on price, and few opportunities for investors to do so, the open and fair marlcets that we rely on are neither open nor fair."*

Although Nasdaq dealers justify the spread by stating they talce die risk of owning the stock, many keep low inventories. In fact some stocks can have markets of only 100 by 100, or 500 by 500. This means that if you come to the dealer, 100 or 500 shares is all he has to trade at the price he posts. The lower the ti-ading volume, the smaller the position the dealer is required to take and the higher the spread, particularly for low-priced, small-company stocks. In effect, the risk factor is often not large for the dealers, particularly when they have a spread of 20% or more, but its great sleight of hand. Too, many of die dealers will back away from their bids or offers, even though diey are often only for nominal amounts of stock. On October 19, 1995, for example, Morgan Stanley, one of the brokerage house giants, walked away from buying 500 shares of Intuit, Inc., at $49.25, which was its bid (the price Morgan Stanley was required to buy at to make a market). It continued to post $49.25 as the price it would pay for the stock for at least another 12 minutes.

"Backing away" by the dealers results in investors paying higher prices when they buy, and receiving lower ones when they sell. Veteran traders say backing away occurs because there is litde risk of penalty by the N.A.S.D. (National Association of Securities Dealers). To compound the problem, most traders are not interested in making a market but are primarily trading for their own accounts in the stocks in which they are market makers, according to Robert M. Gintel, of the Gintel Group of Mutual Funds. The dealers post quotes because Nasdaq rules require them to do so. But, said Gintel, "Out of twenty market makers for a stock, maybe two are interested in trading at any given time." The rest, he said, "will scurry like rabbits to get out of the way" of unsolicited trades, swiftly changing dieir quotes if an unwanted order comes in on which they cannot make an instant profit. Having traded myself in Nasdaq markets since its beginnings, I have seen this happen many times.

But, unfortunately, theres more. The staggering spreads are only the tip of the iceberg on thinly traded stocks. The purchase or sale can move the stock an additional 10% or more. When you come in to buy more than a minimal amount, the price goes up, even if the spread itself is already large. The dealers bid naturally drops when there is a more-than-nominal order to sell and rises when there is a more-than-marginal amount to buy.

Let me give you an illustration. Several years back a friend of mine

tried to buy 30,000 shares of a stock called Westem Transmedia, then listed on Nasdaqs bulletin board. The bulletin board is a section of Nasdaq that trades 7,000 tiny companies with minimal liquidity and enormous spreads. The stock had close to seven million shares outstanding, and traded at $3M bid, $4Moffered, or a modest spread of 30%. When my friend attempted to buy these shares, the stock moved up rapidly to 6A bid, 1% offered. Either the dealers had no inventory, or got wind of the size of the order, or both. There were no news announcements from the company or analysts reports during this period. The cost to buy had risen a whopping 67%. Wisely, my friend canceled his buy order, whereupon the stock fell back to its original spread of 3M to 4M in weeks. Anyone see a slice more of that extra, small-company retum disappearing here?

In late 1997, feeling the hot breath of Big Brother behind it, Nasdaq cracked down on its bulletin board by proposing stricter standards to the SEC. Though the Nasdaq name and its electronic trading system make it appear to be a regulated stock market, the bulletin board had almost no mles and no listing requirements. Said Barry R. Goldsmith, Nasdaqs chief enforcement officer, "It had the look and feel of a highly regulated market, and that was enabling people to 1 1 frauds."" In order to be listed, the only requirement was one broker who could act as a market maker. Not only were the spreads out of sight, but it was a hotbed of stock-market fraud because of serious manipulation by a number of un-scmpulous brokerage firms. The crackdown came after the SEC investigations and F.B.I, sting in October 1996 of shady brokerage houses trading in smaller company stocks, which has resulted in the recent indictment of 55 promoters, brokers and small-company officers for fraud, with the probability of more coming. Talk about closing the bam door...

In bad markets or panic, as in the case of the crash of 1987, you dont have to worry about spreads-or for that matter fraud. The dealers simply vanish or dont answer their phones, as a number of major commissions investigating the crash brought out. This is classic price-gouging. There are few places where it is tolerated more than in trading small stocks.

Nasdaq was long considered a "club," mled by a powerful trading committee made up of the executives of 18 large brokerage firms that traded heavily in Nasdaq stocks. The spreads allegedly have been vigorously "policed" by the club. Thus market-makers narrowing their spreads have been chastised by senior members of the club for raising their buying price above those of other members or lowering their selling prices. If the market-maker has been really naughty he is, as in any