What Is SOES Bandits?

SOES bandits are a group of individual investors who exploited the Nasdaq’s Small Order Execution System (SOES) for day trading. While the bandit's average profit per trade is small, they make up for it by trading dozens or hundreds of times per week. Bandits usually establish a position prior to most market-makers having updated their quotes and lay off the positions at favorable prices.

An interesting sidenote to the SOES bandit story was their ability to profit off professional market markers despite a comparative disadvantage in information capabilities. Because bandits reap the profits and bear the losses from their trades, perhaps they were sharper given greater incentives to perform better than traditional market making firms.

Understanding the SOES Bandits

Today's man vs. machine debate has its origins in the story leading up to the SOES bandits saga. In many ways, the October 19, 1987, crash of Dow Jones Industrial Average helped plant the seeds for high-frequency trading. Now known as Black Monday, the Dow fell nearly 23 percent, its biggest one-day decline ever. With stocks dropping so quickly, many Nasdaq market makers—the middlemen who grease the markets’ wheels—simply stopped picking up their phones. Retail investors were left unable to protect their portfolios.

Recognizing an opportunity, a small group of investors looked to exploit a hole in the market's process. This hole arose because SOES trades are automated, receiving near instant execution.

Thus, these trades are given priority ahead of the rest of the market. This allowed fast traders to move in and out of stocks using SOES at a more rapid rate than large investors, which ended up generating big profits.

The original SOES bandits were Sheldon Maschler and Harvey Houtkin of the now infamous, Datek Securities. With the help of Jeff Citron and Josh Levine, in 1989 they created a software program dubbed Watcher, which allowed day traders to take advantage of the SOES system's weakness in slowly updating of price quotes.

Although only intended for small orders, Datek was using the SOES system for large trades, essentially buying stocks and then selling them again within a matter of seconds. By 1996 Datek had scalped so many trades they were employing over 500 traders, a great deal of them just out of Ivy League schools.

The success of Datek Securities and other early high-frequency traders went on to spark an Electronic Communications Network (ECN), named Island, followed by the the Archipelago ECN, which merged with the New York Stock Exchange in 2006.