INTRO: If you’re invested in the financial markets,
I’m sure you’ve heard of these big bad institutions called market makers.
We’re often told horror stories that these guys have full control of the market, and
that they manipulate it on a constant basis to suck out as much money as possible from
the average retail investor.
Likely the most famous example of a market maker allegedly abusing their power to influence
a stock was during the Gamestop run when Citadel apparently pressured robinhood to halt the
buying of Gamestop.
This portrayal has given market makers a pretty bad reputation, and to be honest, most market
makers don’t deserve anything better.
However, the concept of market makers wasn’t invented out of bad faith.
In fact, market makers were supposed to help markets run smoothly and efficiently both
for retail investors and institutional investors.
And you could argue that they still accomplish this despite their bad reputation.
But, who exactly are market makers, what exactly do they do, and why do so many investors despise
market makers?
WHAT IS A MARKET MAKER?: Starting off what the basics, let’s take
a look at what exactly a market maker is.
A market maker is simply an individual or institution that partners with an exchange
to increase liquidity on the exchange.
The way they accomplish this is by acting as both buyers and sellers for all the securities
that are traded on the exchange.
Here’s the thing, there’s not always people out there that are willing to buy the stock
your selling or sell you the stock that you want to buy.
This is especially true if you’re trying to sell or buy a massive amount of stock with
low volume.
And this is where market makers step in.
These guys will guarantee to buy or sell the given stock at prices that are just below
or just above the market price.
These guaranteed offers are called the bid and ask price.
For example, let’s take a look at GameStop’s bid and ask prices when the stock was at $136.50.
As you can see, the bid price is $136.12 and the ask price is $136.55.
This means that a market maker is willing to buy Gamestop from you for $136.12 right
now regardless of whether there’s a buyer on the other side.
Similarly, a market maker is willing to sell Gamestop to you for $136.55 regardless of
whether there’s a seller on the other side.
If you put in a market order to buy or sell shares as fast as possible, these are the
prices that they’ll execute at.
If you look closer at these bid and ask prices, you’ll see that there’s the phrase x1
right next to either price.
This indicates how many shares market makers are willing to buy or sell at these prices.
Generally, their offers are measured in units of 100 shares because this is the minimum
that market makers are required to offer at any given time.
Clearly, market makers aren’t willing to offer more than the minimum with Gamestop,
but with more established stocks, their offers are much more substantial.
With Apple, for example, market makers are currently willing to buy 3900 shares at $149.99
and sell 19,700 shares at $150.
As you can see, these offers make it very difficult for the average retail investor
to ever run into a liquidity problem and this makes sense given that that’s the main purpose
of a market maker.
MAKING MONEY: Alright, so market makers aim to make financial
markets more efficient and liquid, but how exactly do they make money?
Well, the answer is obvious, market makers never actually buy or sell at the current
market price.
Their offers to buy are always slightly lower than the market price and their offers to
sell are always slight higher than the market price.
So, they’re automatically in profit the second that they execute you’re trade, but
here’s the catch.
This profit is just on paper.
As a retail investor, you can easily translate paper profits to realized profits by buying
or selling shares to market makers.
But, for market makers to realize their gains, they actually have to find someone who’s
willing take on the otherside of the trade.
For high volume stocks, this is not too difficult and that’s why the difference between the
bid and the ask is just 1 cent for Apple.
But, for a stock like Gamestop, the spread is far larger at 43 cents.
While spreads makes it easier for market makers to flip their shares for a profit, this is
not always possible because stocks aren’t exactly stable.
In fact, they’re rarely stable, and they’re usually going up or going down meaning that
there’s an imbalance between buyers and sellers.
And given that market makers always have to be willing to buy or sell regardless of whether
a security is running up or selling off, market makers inevitably end up with a long or short
position themselves.
But, this is ok because market makers don’t actually try to make a profit on every single
share they buy or sell because that’s simply impossible.
Rather, they focus on the average price of their net position and ensure that it’s
favorable relative to the current market price.
For example, if a market maker were to accumulate a long position, their goal would be to ensure
that their average price is less than the market price.
Conversely, if a market maker were to accumulate a short position, their goal would be to ensure
that their average price is more than the market price.
If at any point, either of these become untrue, we’ll see the bid ask spread naturally widen
as market makers pull back try to get back into a profitable position.
If this is all that market makers did, there wouldn’t be a problem.
In fact, market makers would likely be appreciated for providing liquidity and efficiency to
the financial markets.
However, as you would guess, market makers often use their leverage and influence to
manipulate the markets to make even more money.
MANIPULATION TACTICS: Given that market makers have been around
for decades, they’ve gotten extremely good at manipulating the markets.
They use countless strategies to move the markets in the favor, but we’ll stick to
the most common strategies starting with bear and bull raiding.
This is likely the simplest form of manipulation as market makers are essentially just buying
or selling large amounts of securities to move the price in a specific direction.
But what makes this strategy so powerful is how strategically market makers use it.
For example, lets say a market maker wants Apple stock to fall.
Maybe they have a short position on the company or they want to buy in cheaper.
What they’ll do is wait for Apple stock to reach a price at which there’s a bunch
of stop losses.
And as Apple nears this price, the market maker will go out and dump a bunch of Apple
stock.
This will trigger the stop losses which will cause a domino effect of selling and fear,
and before you know it, the stock will be down 4 or 5% giving the market maker the perfect
opportunity to close their short positions or buy in lower.
This same strategy works on the other side as well.
If a stock is approaching a critical break out level with a bunch of limit buy orders,
the market maker can buy a good amount of shares right underneath this level and cause
a buying frenzy.
This buying frenzy wont last long as the market maker will be dumping their positions into
this strength causing the price to drop back underneath the critical level.
This is usually what’s happening when we see fake outs like these.
Another popular maniupation tactic is spoofing the tape.
This is when market makers put in phony orders into the order book to mislead traders.
For example, let’s say Apple is trading at $101 per share.
A malicious market maker might go ahead and put in a buy order for a million Apple shares
at $100 per share.
Seeing this massive order, retail traders are often led to believe that a massive whale
is buying Apple at $100.
If they’re willing to put in so much money into Apple, surely, they must know something
right?
Well, they don’t, but retail investors don’t know that and they’ll go ahead and put in
their own buy orders at $100.
Right before the stock actually hits $100 though, the market maker will cancel their
order meaning that it’s just the retail investors who are left buying Apple.
In this scenario, the market makers were able to add significant buying pressure to Apple
without spending a single cent themselves.
They can use this same strategy to the upside as well and create a bunch of selling pressure.
Yet another manipulation tactic that market makers use is the news cycle and one of the
most prominent examples of this is earnings season.
Even the most seasoned of traders don’t trade during earnings because they know that
market makers are in full control.
They might sell the stock into a strong earnings report and buy the stock as soon as the report
drops.
Or, they might sell the stock into a weak earnings report and sell it even more the
second the report drops.
This is when you hear things like buy the rumor and sell the news or sell the rumor
and buy the fact.
While these phrases sound smart, you usually have no clue what the market makers have planned
until it’s already too late.
But unfortunately, beginners often buy or sell thinking they know what they’re doing
and usually, they just get obliterated.
One thing to note though is that all these manipulation tactics only hurt you if you’re
trading, and it’s actually why it’s so hard to be a successful trader in the first
place.
If you simply stick to buying and holding though, you don’t have to worry about any
of this.
PAYMENT FOR ORDER FLOW: All of the manipulation tactics that we’ve
discussed so far have been around for ages, but something that’s gained a lot of attention
in recent history is payment for order flow.
Payment for order flow is when market makers pay brokerages for the opportunity to execute
their trades.
This is one of the primary methods that “quote on quote” free brokerages like Robinhood
make their money.
The problem with this strategy is that it’s consequences are not that favorable for the
end user.
For example, brokerages should be trying to get the best prices they can for you to buy
or sell your shares.
Traditionally, brokerages can shop around at a bunch of market makers to get the best
quotes possible.
But when a brokerage locks in with a market maker in return for payment, they’re giving
the market maker substantial pricing power.
The market maker no longer has to offer the best bid and ask prices.
Instead, they can widen the spread to maximize their own profits.
This was actually a major problem in the late 1990s when we first saw zero commission brokers
gain popularity.
At the time, the smallest spreads on these brokerages was $0.125.
This means that if you were selling 100 shares, you were losing out on as much as $12.50.
Clearly, this is a clear conflict of interest and that’s why many countries such the UK,
Australia, and Canada have banned the practice.
However, the practice is still legal within the US and more and more brokerages have turned
to payment for order flow in order to stay competitive with other brokarges.
And these guys generally make tens of millions if not hundreds of millions every quarter
just from selling your order flow.
For example, in Q2 of 2020, TD ameritrde made $324 million, Etrade made $110 million, Schwab
made $66 million and Robinhood made $180 million all from payment for order flow.
And that’s just the money that the brokerages made from the practice.
The only reason that market makers are paying these massive fees is because they have even
more to gain from the practice.
MARKET MAKERS EXPLAINED: As you can see, market makers aren’t there
to screw you over.
They’re actually meant to help you sell and buy shares whenever you want.
And if you’re a long term investor, market makers have likely helped you way more than
they’ve hurt you.
If you’re a short term trader, however, it’s a completely different story.
Market makers make much of their money from manipulating the markets and misleading small
time investors into buying and selling at the worst times possible.
And while we can complain about them all we want, I think the best idea is to just avoid
the situation altogether and simply dollar cost average into whatever you’re looking
to buy, but that’s just what I think.
Do you guys think market makers are a net positive or a net negative?
Comment that down below.
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