Understanding Market Maker – Part 1

By January 11, 2015 Newsletter No Comments

A very intelligent trader once said, “It is always prudent to respect the wishes of the three most significant “M’s” in your life. These are the following:

* Mother Nature
* Mother-in-law
* Market Maker

A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread. It is our duty as a trader (investor) to protect ourselves from the markets maker due to the position and power they hold. Therefore, it is imperative on us that we understand how markets maker functions in stock market.

Did You Watch (2)

The markets maker’s job is to match trades between buyers and sellers. This causes liquidity in the market. Also, this helps to maintain a market that is fair and equitable. In order to achieve this type of market, the markets maker must be very adept at raising and lowering the price of a stock based on the supply and demand of that stock. In addition, this adjustment in stock pricing helps the markets maker to control the inflow and outflow of that stock from his inventory.

Every stock has a finite number of shares that trade at any given time. The only way that a market maker can perform his duties, and make a profit, is to replenish his inventory.

He does this is one of two ways. First, the market maker raises the price of an undervalued stock. The result is those who own the stock at a lower price will sell it to the market maker who, in turn, will sell it to someone else.

Second, the market maker lowers the price of an overvalued stock. The result is the same as before. Those holding the stock will sell it back to the market maker. His inventory will be in excess since traders will not be willing to pay for the over-priced stock. This causes the markets maker to lower the price of the stock until his inventory is reduced.

A very simple analogy is to consider the market maker as a manager who sells products out of a warehouse. The manager, just like the market maker, must control his inventory. He never wants his warehouse too empty or too full!

MarketMaker

To better understand the qualifications of a market maker, let’s consider his financial requirements. To be a market maker he must control a minimum of 500,000 shares of the stock for which he is making the market. This means that for a $50 stock, for example, the markets maker has a minimum of $25 million invested in that stock as inventory.

Obviously, this is a tremendous commitment that only a few can afford. With this kind of money at risk, it is easy to realize why market maker must be very good at selecting the bid and ask price of a stock or option. When market maker publishes his prices, he is guaranteeing that he will buy or sell up to a 1000 shares of that stock at that price, per transaction. The markets maker is free to conduct transactions in larger amounts, if he wishes.

As an example, you place an order to buy 2000 shares of a stock. Then, the demand for this stock suddenly rises. In this scenario, it is very likely that only 1000 shares of your order will be filled. For the remaining 1000 shares, you may only receive a small portion of this amount or none at all. Depending on the type of order that you placed, you may have the opportunity to purchase the unfilled portion of your order but at a higher price.

At this point, I hope that you have come to the realization that market makers have the ability to drastically take advantage of the uneducated trader.

Let’s consider how this may happen by understanding the elements of a market order. A market order tells the market maker that you are willing to buy or sell your stock or option for whatever the market is paying at the time it is filled.

For example, suppose that late some evening, when the markets are closed, there is good news regarding the company Apple, Inc. (AAPL). Immediately, you place a market order to buy 100 shares of AAPL at the market price, which was $119 per share when the markets closed that afternoon (November 26th, 2014).

The next morning, orders to buy AAPL are stacking up on the market maker’s order queue. Since there is huge demand for the stock, the market maker sets the opening price at $120 per share. This demand continues and the price of the stock increases to $121 per share; which is the price your order gets filled! You had expectations of buying the stock for $119.50 per share.

Next, the demand for AAPL, at $121 per share, diminishes and the price falls to $120 per share, which is the closing price for that day. In this very realistic scenario, you are completely at the mercy of the market maker.

Therefore, it is always advisable to buy a stock using a limit order. With this type of purchase request, your order can only be filled at the price you specified. If, after you place your order, the stock’s price changes unfavorably, you simply cancel your limit order. An informed trader knows that there is always another, possibly more profitable, trade to be discovered. This type of order management leaves the trader in complete control of his purchase price. We will discuss other types of orders in our next article (Understanding Market Maker Part 2).

Please be sure to read the next article on Market Maker.

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