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How You Can Play to Win When Market Makers Are Calling the Shots

InvestorEducation / Learning to Invest Aug 28, 2014 - 05:45 PM GMT

By: Don_Miller

InvestorEducation

The American Legion sponsored a carnival every summer when I was a young lad. My dad was a legionnaire, so each year I had a job. Beginning at age 12, I hauled soft drinks and food to the various concession booths well into the night, which probably violated some labor laws.

Dad warned me about the carnival barkers, telling me to never play games where you try to win a giant teddy bear. They were rigged, he said, and no one ever wins—“So don’t waste your money.”


I questioned Dad’s advice when I saw other boys carrying giant teddy bears to the delight of cute teenage girls. So I quietly watched some of the games. Some people won silly goldfish, but few won the giant teddy bear.

Then I befriended some of the carnival workers and told them what my dad had said. To my surprise, they took his remarks personally. Each one stepped outside his booth to demonstrate just how easy it was to win by pinging ducks or knocking over little stuffed clowns with ease. The guy who shot the BBs told me to ignore the rear sights because they were off center. He also told me exactly where to hit the moving duck to make it go down. Ping, ping, ping! He knocked them down one after another.

He argued that the game was not rigged; if it were, eventually no one would play. But the odds were tilted toward those who practiced. I tried it, lost a dollar (one hour’s pay), and realized it was cheaper to buy the teddy bear than to spend the money to learn how to win consistently.

I think about those carnival games often, when friends and readers ask about market makers, brokers who help keep markets liquid and profit in the process. Do they just hold a unique position, or is something fishy going on?

24 Men Make History Under a Buttonwood Tree

Let’s take a step back to answer that question. The history of what would later become the New York Stock Exchange began in 1792, when 24 brokers and merchants signed the Buttonwood Agreement outside 68 Wall Street—under a buttonwood tree, of course.

The securities market grew, particularly in the aftermath of the War of 1812, and in 1817, a group of brokers established the New York Stock & Exchange Board (NYS&EB) at 40 Wall Street. At that time, stocks were traded in a “call market” during one morning and one afternoon trading session each day. A call market is exactly what it sounds like: a list of stocks was read aloud as brokers traded each in turn.

Whatever the benefits of this seemingly orderly system, it did not foster liquidity, and in 1871 the exchange, which had been rechristened as the New York Stock Exchange (NYSE) in 1863, began trading stocks continually throughout the day. Under the new system, brokers dealing in one stock stayed put at a set location on the trading floor. This was the birth of the specialist.

Designated Market Makers (DMMs), who are assigned to various securities listed on the exchange, have since replaced specialists. DMMs are one type of market marker, which are broker-dealers who streamline trading and make markets more liquid by posting bid and ask prices and maintaining inventories of specific shares.

Since the NYSE is an auction-based market, where traders meet in-person on the floor of the exchange, the DMMs, who represent firms, maintain a physical presence on the floor. Unlike the NYSE, the National Association of Securities Dealers Automated Quotations (NASDAQ) is an exclusively electronic exchange. Plus, it has approximately 300 competing market makers (not physically present at the exchange). Stocks listed on the Nasdaq have an average of 14 market makers per stock, and they are all required to post firm bid and ask prices.

Why Market Makers Matter to Retail Investors

You may be thinking, “That’s great, but why should any of this matter to me?” Well, because the existence of market makers should affect a few of your trading habits—for thinly traded stocks in particular.

Trades are not automatically executed via magical computer elves. When you place a buy or sell order (likely via the Internet), your broker can choose how to execute your trade.

When you place an order for a stock listed on the NYSE or some other exchange, your broker can pass that order on to that particular exchange, or it can send it to another exchange, such as a regional exchange. However, your broker also has the option of sending your order to a third market maker, a firm ready to buy and sell at a publicly quoted price. It’s worthwhile to note that some market makers actually pay brokers to route orders their way—say, a about penny or so per share.

On the other hand, your broker will likely send your order for a stock traded on the Nasdaq, an over-the-counter market, to one of the competing Nasdaq market makers.

And of course, your broker can always fill your order out of its own inventory in order to make money on the spread—the difference between the purchase and sale prices. Or it can send your order (limit orders in particular), to an electronic communications network (ENC), where buy and sell orders of the same price are automatically matched.

With that in mind, there are two steps you should take to make the most of your trades:

  • Always place orders at limit prices, as opposed to market prices. As of Tuesday, the price for Coca-Cola is a bid of $41.23, and the ask price is $41.24; the spread is a penny.

    If you put in an order to buy at $41.24, a market maker could buy at $41.23 and sell it to you for $41.24, pocketing a penny per share. If you buy 100 shares, they make $1.00. That is their profit for making the market.

    If you put an order in at “market,” it can cost you a lot more. The depth of the current bids goes all the way down to buy at $34.01 (there are a couple of orders to buy KO for $22.12 and even one as low as $3.00, but the probability they will be filled is negligible), and the sell side goes up to $53.68 (again, there is one order to sell KO at $88 but this investor won’t find a counterparty in his right mind that would take it). That means there are currently orders sitting with the market maker to be executed at those respective prices.

    If the market maker sees a market order, he would buy the stock at $41.23 and sell it at a much higher price. A market order is basically a license for the market maker to steal. You want the best price for any stock you’re trading; entering a market order will ensure you don’t get it.

    The spreads for thinly traded stocks are generally larger. If you want to buy, you can offer a lower price than the bid, or perhaps a penny higher. If you want to trade several thousand shares, consider doing so in small tranches, so you don’t show your full hand to the market maker.
  • Know the role market makers play when executing stop losses. For the Miller's Money Forever portfolio we generally set a trailing stop loss when we buy a stock. Entering a stop loss order with your broker will automatically generate a sell order should the stock drop to that number. A market maker can see that number and may drop down to buy your stock at the low price and then resell it for a profit.

    As a practical matter, I set stop losses for big companies like Coca-Cola that trade millions of shares per day. The stop loss was there for a reason, and I don’t want to risk the price dropping further before I can sell it.

    Some pundits think you should never enter a stop loss with your broker. They prefer another method: a stop loss alert, which many brokerage firms offer. They notify you through an email or text message if the stock drops to the stop loss price, and then you can go to your computer and enter the sell order. We always use the alert for thinly traded stocks, so we’re less vulnerable to an aggressive market maker.

    If you are concerned about showing your hand to the market maker, by all means, use a stop loss alert. If you think the risk associated with stop losses is minimal for high-volume stocks, you may want to use both stop losses and stop loss alerts, depending on the stock.

Whether any of this means the market is “rigged,” I’ll leave to those $500-per-hour lawyers to hash out. This is the game we’re playing, so it’s critical to understand the rules, whether we like them or not.

Whether you’re a retail investor or just a guy shooting at moving ducks at a carnival, you need knowledge and skills to succeed. My free weekly missive, Miller’s Money Weekly, exists for that very reason. We provide retirement investors with the education and tools essential for a rich retirement. Receive your complimentary copy each Thursday by signing up here.

The article How You Can Play to Win When Market Makers Are Calling the Shots was originally published at millersmoney.com.

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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