QUOTE
The role of the market maker
A market maker runs a ‘shop’ and investors buy shares from him or sell them back to him. The rules for SEAQ stocks insist that all share transactions must go through a market maker.
The market makers act as retailers of shares and display their prices during working hours (8.00-4.30pm). The prices may vary (sometimes considerably) during the day, depending on a number of influences.
For example, if the holder of a very large amount of a share decides to sell (or many holders of small amounts), the market makers will reduce the price they are prepared to pay for the share. The converse is true also; if there is a consistent and large enough demand for a share, then the market makers will increase the price.
Market makers make money from buying shares at a lower price to which they sell them. This is the bid/offer spread. The more actively a share is traded, the more money a market maker makes.
It is often felt that the market makers manipulate the prices. However, ‘market manipulation’ is an emotive term that conjures up images of shady deals and exploitation. In fact, they are not elusive companies that appear then vanish overnight. They are duty bound to make a market and to meet the needs of those they are responsible to, so to this end they may try to influence the market.
However, market makers are known to lower prices to ‘panic’ investors into selling, sometimes called ‘shaking the tree’. Moving the price up encourages sells, moving it down also encourages sells. The opposite is a ‘dread cat bounce’, a false mark-up to catch out all those bottom fishers or falling knife catchers.
One of the myths surrounding market makers is that they take positions in the stocks they quote, the usual cry is “the market makers are shorting this stock; that’s why the price is going down”. Wrong. Market makers make money by churning stocks, not by taking a position. This does not mean that they do not end up with an excess or a shortage of stock but the cost of holding and the risk of being the wrong side does not make commercial sense.
A market maker who is over-exposed to the market is injecting systematic risk to the whole market. If he was to take up many large positions across the whole range of shares he makes a market in, then any market crash would see him bankrupt (a la Nick Leeson and Barings) and therefore unable to make a market. Once the market vanishes, the shares become pretty worthless (if you cannot sell something at any price, what is it worth?). This, in turn, could force other market makers to go bankrupt and the whole thing would lead to a market meltdown.
Consider for one moment an analogy of market makers and bookmakers. They both make a ‘book’ and in many ways operate in the same fashion. Imagine standing in the betting ring at a racecourse. You look around all the bookings’ stands and see the horse you want to back being offered at differing prices. You naturally go to they bookie who will offer you the best odds.
Let’s say Fred is offering 15-1 on the horse you want to back, whereas the other bookie (Ted & Ned) is on 14-1 or further out. Fred will take your bet at 15-1 and will continue to take other bets until he feels he has taken on enough risk at that price. When his book is full, he will move his price down. Meanwhile, Ted & Ned notice that their prices are not bringing in the business, and move their prices up to equal Fred’s, or indeed higher, to put themselves on the price. If a bookie takes on too much risk on any one horse, he will ‘lay off’ the bet among other bookies to share the risks. The whole business is a combination of simple demand/supply economics with a twist of risk.
Market makers work in exactly the same way, moving their prices to encourage buyers and detract sellers and vice versa. Likewise they can partially rebalance their books either by enticing trades by becoming ultra competitive or indeed ‘laying off’ by selling to another market maker direct.
A market maker runs a ‘shop’ and investors buy shares from him or sell them back to him. The rules for SEAQ stocks insist that all share transactions must go through a market maker.
The market makers act as retailers of shares and display their prices during working hours (8.00-4.30pm). The prices may vary (sometimes considerably) during the day, depending on a number of influences.
For example, if the holder of a very large amount of a share decides to sell (or many holders of small amounts), the market makers will reduce the price they are prepared to pay for the share. The converse is true also; if there is a consistent and large enough demand for a share, then the market makers will increase the price.
Market makers make money from buying shares at a lower price to which they sell them. This is the bid/offer spread. The more actively a share is traded, the more money a market maker makes.
It is often felt that the market makers manipulate the prices. However, ‘market manipulation’ is an emotive term that conjures up images of shady deals and exploitation. In fact, they are not elusive companies that appear then vanish overnight. They are duty bound to make a market and to meet the needs of those they are responsible to, so to this end they may try to influence the market.
However, market makers are known to lower prices to ‘panic’ investors into selling, sometimes called ‘shaking the tree’. Moving the price up encourages sells, moving it down also encourages sells. The opposite is a ‘dread cat bounce’, a false mark-up to catch out all those bottom fishers or falling knife catchers.
One of the myths surrounding market makers is that they take positions in the stocks they quote, the usual cry is “the market makers are shorting this stock; that’s why the price is going down”. Wrong. Market makers make money by churning stocks, not by taking a position. This does not mean that they do not end up with an excess or a shortage of stock but the cost of holding and the risk of being the wrong side does not make commercial sense.
A market maker who is over-exposed to the market is injecting systematic risk to the whole market. If he was to take up many large positions across the whole range of shares he makes a market in, then any market crash would see him bankrupt (a la Nick Leeson and Barings) and therefore unable to make a market. Once the market vanishes, the shares become pretty worthless (if you cannot sell something at any price, what is it worth?). This, in turn, could force other market makers to go bankrupt and the whole thing would lead to a market meltdown.
Consider for one moment an analogy of market makers and bookmakers. They both make a ‘book’ and in many ways operate in the same fashion. Imagine standing in the betting ring at a racecourse. You look around all the bookings’ stands and see the horse you want to back being offered at differing prices. You naturally go to they bookie who will offer you the best odds.
Let’s say Fred is offering 15-1 on the horse you want to back, whereas the other bookie (Ted & Ned) is on 14-1 or further out. Fred will take your bet at 15-1 and will continue to take other bets until he feels he has taken on enough risk at that price. When his book is full, he will move his price down. Meanwhile, Ted & Ned notice that their prices are not bringing in the business, and move their prices up to equal Fred’s, or indeed higher, to put themselves on the price. If a bookie takes on too much risk on any one horse, he will ‘lay off’ the bet among other bookies to share the risks. The whole business is a combination of simple demand/supply economics with a twist of risk.
Market makers work in exactly the same way, moving their prices to encourage buyers and detract sellers and vice versa. Likewise they can partially rebalance their books either by enticing trades by becoming ultra competitive or indeed ‘laying off’ by selling to another market maker direct.
This is what a typical Level 2 screen looks like for a SEAQ (small cap) traded stock:
Now, without Level 2 info, this is what you would see…
Bid = 225
Offer = 240
Mid price = 232.5 (+9.41%)
So, the stock is rising & you want to buy – do you buy right now, or see if it falls back a bit? There’s no way of knowing if the next move is going to be a tick up on the offer, or a drop in the bid price.
However, with Level 2 you can see that there are 4 Market Makers currently bidding for peoples shares. They really want your stock and this competition forces them to go higher than the rest in order to be the ones who get your stock when you sell. Anyone who buys right now is going to buy from UBSW @ 240p. USBW can take orders up to 2,000 shares, so anything above this will probably have to pay a higher price (250p). It will only take a few buys before UBSW runs out of stock and need to buy more back & will go onto the bid, pushing the price up further!
As soon as UBSW moves from the offer, the offer price will be 250p
So, you still cannot tell for sure what direction the price will move next, but you now know that a few buys will send the price up, whereas it’ll probably take a lot more sells to push the price down. (4 Market Makers will need to run out of stock!)
In my opinion, Level 2 enables you to benefit in about third of your trades.It helps you cut the odd 1 or 2 percent off your purchase price or add an extra 1 or 2 percent to your sale price.
Level 2 is therefore a useful tool for everybody, but whether it is worth the money depends on how often you trade & with how much money you trade.
Another example: Sometimes I think I should sell a share when it looks like it's going down. So I check Level 2 and see 4 or 5 MMs on the bid. So I wait. If the Level 2 situation worsens I sell (nothing lost, nothing gained). However, sometimes Level 2 improves & the price starts to rise. Voila, I've avoided selling a share that I thought was going to fall, but now it has risen, and the risk of it dropping before I sold is virtually zero because I've kept my eye on Level 2.
These are the very basics, once you watch Level 2 data for a stock day after day, you get to know which market makers are agressive and which ones play by the rules. You can then easily spot when there is a buyer or seller in the background and that enables you to anticipate which way the stock is likely to go when it hits a support or resistance level. I generally only trade small caps, which use the SEAQ system explained above. The SETS market making system works in a different way, which I'm happy to help people with but find it useless when it comes to predicting the share price movement of the big FTSE 350 companies...
SB
its a good tool if you can master it i guess! But i havent managed that yet!
I often come back to it