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Understanding Market Makers

Jul 9, 2024

Understanding Market Makers

Introduction

  • Common perception: Market makers manipulate markets to the detriment of retail investors.
  • Example: Citadel allegedly pressuring Robinhood during the Gamestop run.
  • Market makers' goal: Enhance market efficiency and liquidity.
  • Despite bad reputation, they play a crucial role.

What Is a Market Maker?

  • Definition: Individuals or institutions partnering with an exchange to increase liquidity.
  • Function: Act as buyers and sellers for securities on an exchange.
  • Bid and Ask Prices: Market makers buy below and sell above market prices.
    • Example: GameStop bid ($136.12) and ask ($136.55) prices.
    • Share offer indicators: Usually measured in units of 100 shares.
    • More established stocks like Apple have higher share offers.
  • Role: Prevent liquidity problems, mainly for retail investors.

How Market Makers Make Money

  • Profit Mechanism: Buy below and sell above market prices.
  • Paper vs Realized Profits: To realize gains, market makers must find a counterparty.
    • Easy for high-volume stocks (e.g., Apple), harder for low-volume stocks (e.g., GameStop).
  • Net Position Management:
    • Long position: Average price < market price.
    • Short position: Average price > market price.
    • Bid/ask spread widens if these goals aren't met.

Manipulation Tactics

  • Bear and Bull Raiding:
    • Buying/selling large amounts strategically to trigger stop losses or limit buy orders.
  • Spoofing the Tape:
    • Placing phony orders to mislead traders.
  • News Cycle Manipulation:
    • Control during earnings season, affecting stock prices contrary to logic.
    • Examples: Sell into strong earnings, buy into weak earnings.
  • Impact: Mainly affects short-term traders.

Payment for Order Flow

  • Definition: Market makers paying brokerages to execute trades.
  • Consequences: Not favorable to end-users.
    • Brokerages might lose incentive to get best prices.
  • Historical Context: In the late 1990s, small spreads were problematic.
    • Widespread in the US, banned in the UK, Australia, and Canada.
  • Financial Gains: Massive revenues for brokerages from payment for order flow.
    • Example: Robinhood, TD Ameritrade, ETRADE, Schwab earnings from Q2 2020.

Conclusion

  • Long-Term vs Short-Term Investors:
    • Long-term investors generally benefit from market makers.
    • Short-term traders might be misled.
  • Strategy: Dollar-cost averaging to avoid market manipulations.
  • Question: Are market makers a net positive or negative?
  • Call to Action: Engage, like, and subscribe for more content.

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