In my previous article on “Understanding Market Maker – Part 1” I discussed the importance and functions of market maker and what could happen to us if we place market order to buy a stock.
In this article I will elaborate further on how to protect ourselves from the market maker. Therefore, we need to understand the concept of bid, ask and the spread and what other order types are available to us beside market order.
All stocks and options are quoted in two prices, the bid and the ask. The bid is always quoted first. Bid is the price at which you can sell your stock to the market maker. The bid is always lower than the ask price. The ask is always quoted second and it is the price at which you could buy the stock from the market maker. The difference between the bid and ask is called the spread and it is this spread which is the profit for the market maker.
The size of the spread and price of the stock are determined by supply and demand. The spread on the stock or option generally reflects the confidence that a market maker has in his stock. For example, if the spread in stock is high compared to its usual spread this means market maker is not confident in this stock. He is not sure what will happen to it after all the buying and selling frenzy dies down. Therefore, in order to protect himself from losses he raises the spread. This means he is willing to buy at lot lower price than he is willing to sell. This is red flag and we should avoid trading this stock or option.
The spread in the stock widens when there is a pending news on a stock such as miracle drug is expected to be approved by FDA for XYZ company. These sort of news come out either after market hours or premarket hours. When such news is announced market maker raises the price of a stock which is lot higher than the previous close price of the stock. This phenomenon is called ‘gap up’. It is at this gap up price that he is willing to buy and sell.
Retail traders not realizing what is happening chases the stock. Market maker sells to these retail traders even though he does not have stock in his inventory. In other words market maker is shorting the stock, lets say at $94. Technically the gap price is at some past resistance of the stock where there are lot of sellers waiting to sell the stock as they had bought it previously at $94 and willing to get out at breakeven.
After market maker sells the stock to all the excited buyers at $94 plus change and is short the stock he then starts to lowers the price of the stock since there is no demand for the stock from large institutional buyers. The price of the stock starts to slide downward. Those traders who already had purchased the stock previously at $94 and wanted to see what the stock would do at $94 see the stock starts to decline, they then rushed in to sell the stock and get out as they think this the chance they have to get out at breakeven. In this downward move market maker starts to cover his short position and absorbs all shares which he needed to go flat.
If there are more sellers left and they are willing to get out of the stock at lower price then stock continues to decline. Those who bought the stock today at $94 (since they placed the market order at open) see immediate loss in their account and therefore they like to get out. This creates further selling pressure in the stock. Since market maker is unwilling to buy a declining stock he widens the spread. Then at some point during the day, stock hits the support level and some smart traders see this as opportunity to purchase the stock thinking it is now at bargain price or these traders shorted the stock along with the market maker. The spread at this time stabilizes and stock trades in normal fashion.
Lot of times when the news is expected to come out on a stock the market maker even halts the trading of the stock till he himself confirms the news, and evaluate his inventory and at what price he is willing to open the stock for trading (gap up or gap down). When such situation occurs it is advisable to stay away from the stock (unless you are a pro) as you may find yourself in a big hole after few minutes of trading this stock. To understand the process of gap trading please refer to my two articles “How I Trade Gaps – Part 1 and Part 2”.
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There are other types of orders at trader disposal instead of placing market order.
Limit Order – Lets say the stock has major news announcement and due to this news, stock has gapped up and trading violently up and down. Instead of chasing the stock and placing the order at market price, a trader can place the limit order. The limit order is placed after determining the level where the stock could pullback and hold the support level. In this way you are not at mercy of market maker. In other words you are telling the market maker that you are willing to purchase the stock at your specified price and not a penny more.
There are other types of orders we could discuss here briefly.
Day Order – A day order is only good for that trading day. If it is not filled that day, the order is cancelled. When buying a stock or option I only place day order. When selling a stock or option I sometimes place Good Till Cancel Order (GTC).
Good Till Cancel Order – This is the type of order which remains valid till you cancel the order. If you place the order to sell 100 shares of AAPL at $119, it will remain valid till you cancel. When AAPL shares hit $119 bid it will be sold. Usually brokers keep the good till cancel order active for 30 to 90 days. When I place GTC order I make it valid for premarket and after market trading too besides regular sessions. In this way if stock trades at my desired price during premarket or after market hours then I get filled.
The above article is intended to help you understand the functions of market maker, the type of orders at your disposal (there are many other types of orders available at broker’s platform and you can further explore) and how to avoid costly mistakes.
In nut shell:
Avoid placing market order to buy a stock or option.
Always assume that all news are already factored in the price of the stock, that is why there is a saying “Buy the rumor, sell the news”.
Be vigilant when major news come out in a stock. Evaluate support and resistance, do not haste in buying the stock. If you already have a position in the stock either via. shares or options, the prudent thing is to sell at least half of your position to protect the profit and either hold the other half and sell rest after you notice stock is stabilizing and not much buying is left in the stock. Always assume that big boys already knew the news and they have already bought the stock before the news announcement and they will be selling the stock rather than buying. Unless the news is so good that it warrants further buying. But then how do you know what will happen to the stock? It takes lot of skill and trader can apply the concept of “Opening Price Range Breakout” concept which is explained in my gap articles.