Market makers cover a book of stocks, and while they do set the prices and make the market, they can sometimes be caught off guard. Many of the stocks on SETSqx are driven by sentiment. Aim is not known for being efficient. This means they can sometimes be caught in a bit of a pickle, if they have misjudged the news and opened the stock up too low. We’ll come back to this.
Although market makers set the price, they take on the risk of making a market so that private investors and traders are able to buy and sell during market hours. To compensate for this risk, they will often buy stock from us when we sell at a price below the share price and charge us a price higher than the share price when we wish to buy from them. This is known as the bid-ask spread, and this is how they make their money as the price they will buy from us is almost always lower than the price they will sell to us. They make a financial turn on every trade. The spread is the price of dealing in stocks and in smaller companies often set by the market makers. The job of the market maker is to ensure there is always a market in which we can deal and they facilitate liquidity.
As market makers set the spread, there is the incentive to widen the spread as much as possible to maximise their gains. But wider spreads deter traders. Fewer traders mean fewer turns, and so the market makers’ greed keeps them in check. The most competitive market maker gets the turn, and this is why when volume increases spreads narrow, as competing market makers are jumping over one another to do business. This is why stocks with little interest see wider spreads – a market maker is unlikely to have much stock on their books as they also don’t want the risk of holding an illiquid stock unless they are fairly compensated for that risk in every turn.
When we log into our sharedealing accounts and individual savings accounts (Isas), we type in the stock we want to buy and load up the dealing ticket. With some brokers, we can do a dummy buy and sell, and if we type in 5,000 shares to buy we will get a fixed price, and the same for when we sell. You will see that the buy and the sell price are different, and this is the bid-ask spread in action. That process happens because when we sit at our computers, or log on to our dealing apps, and request a quote, the Retail Service Provider (RSP) network fires off a request for pricing from all market makers dealing in that stock, collects all of the prices, and displays the lowest price to buy or the highest price to sell to us on our screens.
Do market makers have an advantage?
Many private investors believe market makers have an advantage over the rest of the market in that they get the RNS (Regulatory News Search) news first. Well, not while I’ve been trading they haven’t. Up until recently this year, a small-cap company could release a piece of hugely positive news intra-day, and before the market makers had adjusted their price it was possible to clean out the ask of stock at the same price offered before the news came out. Even better, if a piece of bad news came out on a stock you could dump your shares quickly and then even take a short position through a spread bet before the bid had dropped. Surely, if they’d seen it, they would’ve done something?
Unfortunately, that trick is no longer possible with online brokers, as I have noticed when a piece of news now comes out on an illiquid stock intra-day it is impossible to buy or sell a share and no quote is offered online. My guess is that there is now an algorithm in place that shuts off limits in this situation when an RNS is released, which allows the market makers to adjust their pricing and stop being forced to deal before they’ve read the news. However, you can still deal over the telephone – where the market makers are obliged to deal. You can also take a position through a spread bet. In my opinion, market makers should be obliged to deal at the price and size quoted online because this would lead to more liquid markets. It can be frustrating when one intends to trade a profit warning, and all of a sudden the only stock available to buy online is 10 per cent higher than the price quoted on Level 2. If you want to deal but can’t, then this is the time to get on the phone to your broker or open a spread bet position. Market makers know that the vast majority of dealing is online and so they can be relatively flexible about their pricing on Level 2 and what they actually quote online.
Share price spikes
Coming back to the market makers getting in a pickle, spikes can occur in share prices where the stock is illiquid yet there is higher than average volume going through the stock. We know the market makers set the spread and therefore the mid price is used as the share price. This means the share price can even rise or fall on no trades as a market maker ticks up or down on the bid or ask. This combination of the wide spreads and the mid price being used can often mean a stock can move 15 to 25 per cent on just a handful of trades. This only happens on illiquid stocks with a wide spread, because when the market makers tick up their bid price and ask price it can mean a substantial shift.
For example, if we are a looking at a company with a bid-ask spread of 10p-12p, the mid price is 11p. If a buyer takes the market makers’ stock, they then need to replenish that stock and so they will up their bid, perhaps to 11p. This means the mid price is now 11.5p, and the share price is up 4.5 per cent. However, the market makers want to deter anyone from purchasing stock at 12p because they no longer have any, so they increase their ask price to 13p. The mid price is now 12p and the stock has jumped 9.1 per cent from 11p!
This can lead to short-term speculation traders jumping in and this can even push a stock up by 50 per cent when there has been no news. We must always be mindful of suffering FOMO (fear of missing out) and stick to our calculated plans. Short-term speculation can be highly profitable, but the vast majority of those who attempt it lose money, because they either do not have a system in place or they do not have the discipline to follow that system.
These moves are further exacerbated by those exploiting their knowledge of the way market makers operate. We understand already that the market maker’s job is to provide liquidity for the entire market. However, they do not want to hold plenty of stock in an illiquid share. There are often orchestrated pump-and-dump crews operating in small-cap stocks who take advantage of this for their own gain – a market maker who owns a small amount of stock in a share that sometimes trades only a handful of times a week might suddenly be forced to deal 10 times in the space of a few minutes.
In this instance, the market maker would now be net short of stock. That is, they have sold stock that they do not actually have, and so they will need to buy back that stock to close their position. To do this, the market maker has to bid higher for the stock, in order to entice sellers in order to cover their position. But the rise in the share price and sudden spike in volume has now attracted more speculators who then hammer the market maker with buy orders. Market makers are obliged to make a market so they have to deal, and with every order the market maker is increasing their short position on the stock and the price is rising with every buy. This is how spikes are created, as they get chased by speculators and traders, and bid up to high levels.
Tree shake
Once the buyer appetite begins to lessen, the market maker can now use this to their advantage. When the traders stop bidding for stock at high levels and the market maker lowers their bid price, it becomes a Mexican stand-off. A ‘tree shake’ is when the market makers drop the bid in order to lower the share price, in the hope of spooking some private investors into selling their shares. This tactic is employed when buying appetite has weakened, and so the market makers capitalise and widen their spreads to deter further buying.
There are no buyers in the market, but nobody wants to sell at a low price when the market maker was bidding much higher before. Eventually, someone bites, and the market maker then bids lower again. By using tricks like this and making the stock unattractive to buy by widening the spread, the market maker is able to cover their short position on the stock. The speculators who unfortunately bought the top of the spike will now have to sell at the price the market maker is bidding at unless they telephone the order in. There may be more mini spikes in the whole spike cycle and the market maker will play the market accordingly. Handsome profits can be made by speculators and traders who are in and out quickly, or who are able to time the spike, and even take a short position at the top.
If the price comes back down only to meet more demand, then the market makers will run the stock up to the resistance point and widen the spread again. It becomes a case of rinse and repeat.
Tree shakes are not only used in spikes, but whenever the market makers feel they can make a quick turn. In a previous article of mine, ‘The art of stop-losses’ (IC, 23 August 2019 ), we considered the possibility of market makers being able to see stops. Even if they can’t, they know where these are going to be based on looking at a chart. So they yank the price down, shake out some stops, and raise the price again in order to sell the stock on for a quick turn. Market makers are obliged to make a market – but they’ll also make a market for themselves. If you must use physical stops, use them wisely and not in obvious stop-loss liquidity.
Opening risk for market makers
Another way market makers can get hurt is when they misjudge the open. Some market makers will cover numerous stocks and there is no way they can follow the story and sentiment for each one. This is why they check Twitter and bulletin boards (as do a lot of traders – sentiment ultimately shifts prices). Here is an example of when I thought the market makers had been unjustly harsh on an RNS from Anglo African Oil & Gas (AAOG).
We can see that from the close, the market makers gapped the price down on an RNS, which I felt did not warrant a 20 per cent gap down. Therefore, I bet against the market makers and opened up a spread bet long on the bell, which paid off in the first 10 minutes. I knew that sentiment was strong, and that the drill was still going ahead – the catalyst was still intact. I started closing the trade down at 7p and was fully out not long after.
Market maker codes
Despite there being a distinct lack of evidence of this, there are people who will swear blind by market maker codes. This is where a market maker will put a certain amount of stock through Level 2 in order to send a message to his market maker friends. This rumour originated from the US whereby a market maker did claim that market makers worked together if one of them found themselves in an uncomfortable position. While it is possible to put fake trades through the exchange – such as ‘wash trading’ as revealed in the Beaufort Securities scandal, which brought the broker to a collapse – there are far easier ways of market makers communicating with each other, if they really wanted to. But even now people will think a ‘1’ share trade means an RNS is coming, and people trying to ramp the price will literally buy a single share knowing that people trade on this. This is probably due to selective memory – the private investors who believe in codes remember the few times a code ‘worked’, and forget all of the previous times that it did not.
Market maker etiquette
I am quite sure that most readers who have dealt in the market actively will find it amusing when I say that we are supposed to treat market makers with respect. It is considered ‘bad etiquette’ to continuously request a quote and not deal (test liquidity), or accept a quote when the price has moved in our favour. It’s also considered bad form to deal twice in quick succession to take advantage of a price rather than buying it all and paying a premium to get one’s fill in one go. I have even heard of one trader being warned by his broker against arbitraging the market makers. Every now and again, one market maker will be bidding higher than another one is selling. I see this as being a helpful fellow providing liquidity for the market makers and more importantly turning a quick profit, but just be careful as those prices can change at any point.
This trick of arbitraging is still possible as sometimes either a broker or a trader will leave a sell order under the bid or a buy order way above the ask. If we are the highest bidder in the auction, we can quickly spin off the stock we bought for a bargain to the market makers for a quick profit, or take the short side of the trade by selling to the buyer and covering via the RSP. This game has become very popular though, and it’s very difficult to find a trade that nobody jumps on.
Unless your broker warns you that they may terminate your dealing, or you are doing something illegal (which I do not advise), then all is fair in love and war.
You can download Michael’s free book on the UK stockmarket from his website at www.shiftingshares.com
