Using Spread and Net Trading Range to Measure Risk in Suitability Cases

Abstract:     
Suitability is one of the most common issues that arises in securities arbitrations. Yet it is also one of the most difficult issues to resolve. Up to now there has been no easy and reliable way to compare the risk of one stock or portfolio with another stock or portfolio measured as of the time the investment decision in question was made. As I argued in an earlier article, spread is potentially a promising way to measure risk in real time as perceived collectively by competing market makers. But with the advent of decimal quotes and other recent changes in the way stocks are traded, spreads have become more difficult to measure accurately because quote size is often quite limited. As I show here, net trading range (NTR) offers an elegant solution to this problem. NTR measures the range of quotes that the market actually reaches during the day, but it nets out the change in price from open to close, and thus gives an accurate view of the true spread over the course of trading day. Thus, incidentally, NTR addresses a fundamental problem with beta (the prevailing measure of risk). Although beta purports to measure the tendency of a stock to move with the market, it does not adjust for firm-specific (alpha) changes in price. NTR has the added advantage that it is based on uniformly available data for all publicly traded stocks. In short, NTR when averaged over a period of trading days and expressed as a percentage of a stock's closing price is an elegant and fine-grained measure of risk for a stock or portfolio that can be computed with readily available data and used to compare risk from stock to stock and portfolio to portfolio.

Keywords: net trading range, suitability, risk, securities arbitration, broker, recommendation

JEL Classifications: G24, K22

Working Paper Series