Market makers don’t care about fundamentals. They care about supply and demand imbalances which move markets either up or down during the day. Imbalances can last for hours, minutes, or even seconds. If you are a long-term investor, it matters less to you if you pay a few cents more than an active day trader who makes money by clawing every cent, on every trade.
On an average day, market makers make their profit on a decent sized spread. When volume picks up and the spread starts to tighten, the market makers tend to make more money on the total volumes. However, there are opportunities for them to make more money than just the profit on the spread. If you see there are several market makers at the ask price or a cent above, what does it mean to you?
You can get real time data that shows not just the market orders and volumes but also bids, asks, and volumes away from market prices. By subscribing to “Level 2 quotes”, you get to see the market makers on both sides of the trade, the volumes and how much they are above or below the current bid and ask prices. Basically, Level 2 data ranks the best bid and offers and will provide the ID of the market maker. On the NASDAQ, it is a 4-letter identifier; in Canada, it is a triple digit identifier.
Bid prices are arranged from highest to lowest, and offers are arranged from lowest to highest. There is also a time stamp as trades are made but the presentation and format varies among service providers.
In Canada, paid level 2 data for the TSX, and TSX Venture Exchange are available from TMX, Stockwatch, and brokerages such as BMO Investorline, and RBC Direct Investing among others. Some will offer them free to active traders while Credential Direct provides it free to all its customers. Check with your broker as to what they offer. Some have Level 2 quote services for the US stock exchanges including the NYSE, and NASDAQ.
Ask and Bid Side Traps
For example, “stock A” has 5 sellers at the current trading price of $19.95 and 10 more at $19.96, as the average investor, you would think that there are too many sellers. The bid price is $0.30 cents less at $19.65, so for you the upside potential of 1 cent is not worth the downside of 30 cents. By peppering the ask side with tiny trades, the market makers are creating the illusion of selling pressure and the retail investor stays away. Within minutes, the stock price turns around and rises by $1.00 to $21.95. Market makers can set bid side traps as well. The strategy is similar, they clutter the bid side with very small orders to buy at or just above the current price. The uninformed investor takes at look at the demand and suspects that good news is ahead and gets in on the act. Shortly after, the price tanks. By creating the illusion of a buying opportunity, the market makers get to sell their stock to the retail investor before the selling begins. Be careful of being turned around on your head.
This tactic is used after a stock has had a spectacular price rise over a short few days. The market makers may be lacking enough stock in their inventory to cover previous sales or need to cover a naked short sell. Market makers are exempt from requirements to locate stock before shorting and they have one more day than other traders to settle. They need to buy stock at a low price.
It starts with one or two market makers “stomping on the ask price” which means that they will sell stock at the lowest ask, even in the face of heavy buying. They may even lower the offer price or “walk the price down” despite the high demand. It would seem to go against the basics of supply and demand but this is just the cost of doing business for them. This tactic shakes out day traders, momentum traders, or swing traders who are considered “weak” holders and who will not hesitate to sell at the slightest hint of a turnaround or profit-taking. With the market makers “stomping on the ask” and “walking it down” by continually lowering their selling price, they also drive the bid down. It may even fall below what people were eagerly buying them at. Before too long, the weak hands join in the selling and increasing volumes provoke even more “panic” selling. The market makers are usually aware of when the stock finds a bottom and replenish their stock or cover their shorts at the bottom. Those market makers who shorted at the top make money and other market makers made money on the spread or the volume created by the activity. The stock may or may not go up to the daily high once the stomping is over. If it does, that is a bullish signal.
Tight and wide spreads
This is another ploy to entice sellers. The market makers run the stock up with a tight spread in a fast market. Then they cool the buying interest by opening or widening the spread. After the buying has dropped, they lower the offer below the last trade for a small trade. Next they tighten the spread so as to make weak sellers feel they can make a quick profit by selling to them at the bid on the tightened spread. Once the selling begins, the market maker “walks it down” by making small trades on the way down, all the while with tight spreads.
Another tactic is to run the stock up in the morning, shorting along the way and “walking the price down” which is the trader’s terminology for lowering the bids and offers on subsequent small trades. After a few days, buyers are put off or demoralized, volumes dry up and sellers appear, thinking that the price rise is over. Many of the tricks such as posting phony sizes are frowned on by the NASD but may still be fairly common. An example may look like this.
This means they are willing to buy 50 lots or 5000 shares at $40 and sell 5 lots or 500 shares at $40.25. A buyer may decide just to pay $40.25 to get the trade done. In effect, the market maker may actually have a large position in the stock but is posting a bid for a large volume to fool brokers and investors into believing that the stock is going to move higher on big demand. The same ploy can be used on the sell side.
When you give a market order, you are buying shares at whatever the current price is. Using the above example, you may find your order filled at $40.75 and you may think you were last in line in a moving market. The reality could have been that the market makers saw your market order in the basket of orders and bumped up the offer price to fill your order at a much higher selling price. There are checks to limit such occurrences, orders are time stamped on the physical tickets and there is an electronic tally of bids and offers. There is internal monitoring by the market making firm and spot-checking by regulators, but in a fast moving market with high volume, such tactics are difficult to prevent or prove.
The Next Generation Model at the NYSE
Under the old system, the NYSE market makers or specialists had an information advantage. They were able get an advanced look at customer orders before the investing public. This was a benefit for their risking their own capital and for making continuous two-sided markets. It also meant that they could “penny jump” an order by offering liquidity at a price that was a penny better than the posted limit order from the public investor. For example, say you had a buy limit order at $30.00 and you were the highest bid in the market. If a seller wished to sell the stock to you or, “hit the bid”, the transaction would go through at $30.0. However, that may not have been the case, the specialist penny jumped ahead of your order by offering the seller a cent more or $30.01. It was a gray area and considered not illegal because it met the requirement of “price improvement” or a penny better. This was one of the perks given to the market makers which had a duty to prioritize customer limit orders over their own buy and sell transactions at a given price.
This is no longer the case. Under pivotal changes made in 2008, there are now designated market makers or DMMs, which now trade on equal footing with the investing public. They have to take both sides of the trade for a certain part of the day – 10% for the most active socks and have to participate in the market’s open and close. In exchange, DMMs earn the highest rebates from the NYSE for providing liquidity and for maintaining an orderly market. They get 30 cents per 100 shares. Another class of liquidity providers – the supplemental liquidity provider or SLP- was created at the same time. They get 17 cents per 100 shares, provided they meet certain volume and pricing requirements.
And there you have it, an introduction to market makers and the way the system works. This might not make a difference to you if you are a long-term investor, nevertheless, it is interesting and important to understand how the system works.