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. Also, drop a like if you also prefer avoid
market makers games altogether. And of course, consider checking out our international
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