Market Maker Myths

Published in Investing on 13 November 2009

We explore a couple of accusations often levelled at market makers, of which they are usually innocent.

So far in my Investing Basics series, we've looked at how traditional markets are made, and have examined modern computer-based ways of going about things. But people are often confused about how prices are actually set, so today I'll examine one or two issues in a bit more detail, based on genuine complaints that occasionally arise.

Imagine a situation in which a company comes out with some good news -- be it great results, updated forecasts, news of a big contract, or whatever -- and a lot of people want to get in quick, before the price rises. As soon as the market doors are open, legions of investors pile in and start asking their brokers for quotes. But the price has already gone up, and people complain that the market makers have cheated by marking the price up before any trading has taken place.

Misunderstandings

Those complaints are based on a couple of related misunderstandings. Firstly, when the market opens, a share does not have to start at the same price it closed at the previous day, so there is nothing devious at all in marking up the price before opening. Also, people often fail to understand that the prices quoted by market makers at any one time reflect the balance of supply and demand at that time, and they have to pitch their prices so as to be able to both buy and sell the shares.

If a market maker knew that, say, a company had reported earnings 10% better than expected, and opened his books at the closing prices from the previous evening, he simply wouldn't get anyone willing to sell shares (because potential sellers will have heard the good news too), and so he couldn't offer any for us to buy -- market makers tend to keep a relatively small float of shares, which would be depleted almost immediately.

So if it appears that a market maker might be trying to stitch you up by instantly bumping his prices by 10% when you want to buy some, it's because he'll also be having to pay 10% more to entice anyone to sell to him.

Can't buy enough?

A related complaint, when a share price is rising, is that it is impossible to buy any decent amount of the shares, and we hear complaints that market makers are holding back the shares, or hoarding them, waiting for them to go even higher before they sell.

Again, this is just an inevitable result of the balance of supply and demand. While market makers are obliged to always quote prices that they will buy and sell at, they are not obliged to satisfy orders of any desired size -- they are only obliged to meet what is known as the Normal Market Size (NMS) for the stock in question, and for small and thinly traded companies, that can be very small indeed.

It's logical, captain

And it makes a lot of sense. If market makers were obliged to fulfil orders of any size at the stated price, that would imply that anyone wanting to take over the whole company could just demand that the market makers sell all of it to them. But obviously, market makers can only sell the number of shares that they can get hold of themselves, and if there are few sellers, then a small order size is the best they can do.

I noticed an interesting example of this recently, with a company that I bought a small number of shares in -- NXT (LSE: NTX). The most that my broker could get hold of was 10,000 shares (which, at approximately 10p, was only £1,000). But at the same time, I could have sold 250,000 of them. I kept watching, and the maximum number of shares offered at the quoted price dipped as low as 2,500.

What that suggests is not that the market makers are manipulating the share price by hoarding shares instead of selling them, but that there genuinely weren't very many sellers of the shares out there at time.

Supply and demand

With larger companies, like FTSE-100 constituents, which are traded on the electronic SETS system, the normal market sizes are vastly larger than the example here. And casting our minds back to how SETS works, there are no human market makers in the middle, so when we want to buy shares we can only buy at a price that other shareholders are willing to sell at.

And that's really all that market makers try to replicate. Rather than unfairly changing prices or restricting sales in order to maximise their own profits, what they try to do is set the prices at the levels needed to balance supply and demand, similarly to the prices that SETS would produce when directly matching buyers and sellers (but with a larger spread, to cover their own profits).

Alan owns shares in NXT.

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Comments

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rober00 13 Nov 2009 , 5:01pm

Interesting article Alan!!

I have just bought shares in an small investment trust. NMS was 3000, I bought 4000+. Having bought just before the close of play. I notice that the "offer" price dropped by 0.5p below the price I paid (which incidentally had held for most of the afternoon). I presume my purchase moved the "offer" price for some reason?

lotontech 13 Nov 2009 , 6:21pm

Nice article Alan.

I remember writing an analogy in a book recently, comparing a market maker with a used car dealer who stands ready at a moment's notice to buy your car (into his stock-at-hand) or sell you a car (from his stock-at-hand) to save you having to find your own private buyer or seller.

So as to make a profit and manage his risk, he pays you less than market value to take your car off your hands, and sells it on for slightly more than the market value -- equivalent to the bid-ask spread.

He holds fast-selling popular models in large quantities, and fewer of the more esoteric models. His mark-up on the popular models is lower because he can find customers easily, and he faces more competition. His mark-up on the esoteric models is higher because he holds on to them at greater risk (of ultimately not finding a customer).

Tony Loton

Fabius1 15 Nov 2009 , 1:33pm

I agree with the points made. However, for those who are familiar with AIM markets where volume is lower, they may have a slightly different view. Market makers are often a little more creative and do actually 'make markets'. If a MM has a requirement to buy/sell stock or simply drum up business, it may be necessary to 'incentivise' existing holders. They will target the weaker holders with their 'for sale' signs in the form of trailing stops. If they drop the price sufficiently to trigger these automatic sells then they are rewarded with a handful of easy pickings. This can destabilise the market in the stock. There will be holders who are short on conviction so sell and flee for safety. Wily traders know this. They see an opportunity for a quick buck and may short or trigger further selling often resulting in a stampede. At this point, psychology takes precedent over investment and confusion reigns. The smart money waiting in the wings then move in and buy when they perceive value and the price rises. The buyers are happy, the sellers are relieved, the investors are untouched and the MM's go off to the pub. Just another day's work in this fascinating business. A bit like those wonderful David Attenborough nature programmes concerning the hunters and the hunted. All part of the food chain really.

lotontech 16 Nov 2009 , 8:42am

Nice one Fabius!

The thing about Market Makers "taking out" poorly placed Stop Orders may be interpreted by Fools as a reason to avoid Stop Orders at all costs.

But no; it just means that you have to place them intelligently not at obvious levels, and be particularly cautious on very small cap stocks.

Tony.

Iniq 16 Nov 2009 , 9:54am

An excellent, very informative article. Thank you!

I would enjoy more articles like this, giving background information and actual facts, than an endless and tedious stream of articles trying to dream up reasons why "You really need to buy XYZ shares NOW" - i.e., just churning.

Fingered 16 Nov 2009 , 11:30am

Informative article........

The availability/non-availability of a stock or instrument is also known as higher level data known - market depth.


At opening, where a price may gap up or down, there is of course the influence these days
of round-the-clock electronic trading from global particpants in the markets on futures for example that drive this.

Fingered 16 Nov 2009 , 11:52am

On the AIM front, the stocks can be highly illiquid. Sometimes for example, the broker you bought the stock from is the ONLY dealer involved in buying and selling of that stock aqnd you may not be able to even sell it back to them. ! Then of course, there are some unscrupulous outfits that are known in the trade as "chop-shops" ....so beware.

BarrenFluffit 16 Nov 2009 , 11:54am

Ok so where do Retail Service Providers fit in? Online brokers get their quotes not from the markets but from RSP's.

TMFBoing 16 Nov 2009 , 4:56pm

Hi folks,

Many thanks for the kind comments, and for all the additional information and ideas - I intend to cover more issues like this in forthcoming articles.

Foolish best,
Alan
TMFBoing

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