Market Maker

Ways of a MM (Market Maker)

For the most part MM don’t have a clue nor do they care to learn, about the fundamentals of the stocks they trade.

They just try to make orderly markets. When dealing with BB stocks it is very easy for a MM to get trapped into being short in dealing in a fast moving market. Reason being; most of the MM’s in this stock are what are called “wholesalers” this means they don’t have retail brokers “working” the stocks.

So they have to rely on whats know as the “call” from larger retail houses. If a “Big” retail firm like an E-trade calls up a market maker to purchase say 5,000 shares of a stock, they expect to get an “execution” from that market maker. If he turns them down, or only gives a partial then the “Big” firm will go to another MM.

If this second MM “fills the order” then that “Big” firm has a moral obligation to continue to give future “business” in that stock to tha MM who preformed (his life blood). This will go on until he “fails” to perform and so on.

Contrary to popular opinion the “Big” firms Do NOT neccessarly go to the “Low Offer” to fill a buy order (Or high bid for a sell). The “Go” to who they think will perform to fill the order and expect that MM to “match” the “low offer” in the case of a buy (bid in the case of a sell). Even though this MM might in fact be the “high bid” and not really want to sell any more.

As a wholsaler he must perform or he will get a reputation as a “non-performer” with the “Big” houses and will cease getting “calls” which means he will soon go out of business. I mentioned above that this activity is very significant to BB stocks. I say this because most of the trades in these BB stocks are “unsolicited” and are done through discount houses, ergo “Big” firms.

With the above groundwork layed, let me try to explain how market makers get short even if they like the Company; Lets say that a stock (shell) has been lying quitely at $.25 bid $.50 offered. A limit order comes into one of the MM’s to Buy at $.50 for a thousand shares. Prior to this trade that MM may be “flat” (neither long or short any shares). He fill the order and is now short 1,000 shares. He may raise his bid hoping to find a seller to “flatten” out his position. But before he realizes it a wave of buyers have come in and cleared out all the $.50 offers. Now the stock is $.50 bid .75 offered. Here comes that “Big” firm he just sold the 1,000 shares to at .50 with another bid for 1000 at .75. He makes this print. Now he is short 2,000 at an average of .625. The market keeps moving and now its .75 bid 1.00 offered. Now he has to make a decision.

Just like investors, MM Hate to take a loss. So 9 times out of 10 he will now sell 2000 at 1.00 making him short 4000 but with an average 81. At this time he would love to see a seller at .75 so he can cover his short and make a few bucks.

But instead the market keeps moving up. Now it is 1.00 to 1.25 and here comes the buyer again at 1.25. He doesn’t want to loose the call so now he needs to sell 4,000 at 1.25 to keep his break even point above the bid. Now he is short 8,000. Market moves up to 1.25 bid 1.50 offer here comes the buyer now he feels he must sell 8000 here because “stocks don’t go up forever”.

Now he is short 16,000. And so on and so on. If the stock keeps moving up, before he realizes it he could be short 50k or 100k shares (depending how big his bank is).

Finally the market closes for the day and on paper he may look allright in that his “break even” price may be around the closing price. But now he has to figure out how to entice sellers so he can cover this short. It is important to note that if this happened to one MM it has probably happened to most all of them.

Some ways MM’s entice sellers; Run the stock up with a “tight spead” in a fast market, then “open” up the spread to slow down the buying interest. After it has “cooled off” for a little while lower the offer below th last trade right after a small piece trades on the offer then tighten the spread so that the sellers feel they can take a “quick profit” by “hitting the bid” on the tight spread.

Once the selling starts the MM’s will walk it down quickly by only making small prints on the way down with the tight spread. Another way is by running the stock up in the morning, averaging up their short then use the above technique to walk it down in the afternoon.

Hopefully after doing this for several days, it will demoralize the buyers. The volume will dry up and the sellers will materialize thinking that the game is over.

Contrary to popular opinion, MM usually Do Not Cover in Fast moving markets either Up or Down if they are short. They Short More. They usually try to cover after the frenzy is out of the market. There are many other techniques they use but the above are the most popular.

This technique works about 9 times out of 10 particulary in a BB market. However that is because 9 out of 10 BB stocks are BS. Remember what I said above. Most MM’s don’t have a clue as to the value of a Company until they get trapped. If the Company has solid fundementals and a bright future. Then the stock will do very well. And the activity that caused the situation will prove to even help the future stock activity because it created an audience.”

Market makers start their mornings between 8:30 and 9:00 a.m.ET making a guess at where a stock will open. To set the price, they check to see if there’s any news (positive or negative) from the day before that should affect the stock. They also check to see: 1) if there are a lot of buy or sell orders waiting in the queue for the stock; 2) how a stock is trading in overseas markets; and 3) how a stock traded in after-hours trading.

A few minutes before the market opens, the market makers start to adjust their bid and ask prices to make sure that they are in sync with their peers. The key for a market maker is to never take his/her eye off of the other quotes that exist for a stock because if his stock is incorrectly priced, he could lose his shorts (so to speak).

EXAMPLE: Let’s say market maker A has a bid/ask of $7.25/$7.50. That means that the stock can be sold for $7.25 to that market maker and bought from the market maker for $7.50. Meanwhile, market maker B posts a bid/ask of $8/$8.25. Traders would quickly buy stock from A at $7.50 and sell it right away to B at $8 — A $0.50 profit on each share.

So can the bid/ask prices change from one market order to the next? Yes. Market makers are constantly adjusting their prices, often doing so several times between trades. They are jockeying for position against one another in order to be best-positioned to trade their stocks at a profit. As a result, they are more likely to adjust their bid/ask prices in response to each other, rather than in response to orders that are coming in from customers.

Is there anything you can do to predict where a stock will open? Not really. But you can get a sense of whether a stock will open up or down by looking for positive or negative news on a company, how the company is trading in overseas markets and what happened to it overnight in Instinet trading.

Market Makers (MMs), particularly in the OTC/BB market, have a number
of “methods” they can use to help them make more money. Acting within
their “official” capacity MMs are supposed to keep a liquid and
balanced market by regulating the incoming buys and sells. Their goal
is to facilitate trading in particular stocks by utilizing a quotation
network to
post incoming trades and also trades for their own accounts. They trade
amongst each other and a balance is found naturally based on supply and
demand. The spread represents the difference between current
top bid for a stock and the ask which is the minimum the holders are
willing to sell for. Various Market Makers have inventory in the stock
you want to buy from people that sold for their bid price, and because
you buy at the more expensive “ask” price (or thereabouts) the MM’s are
able to pocket the difference for their trouble.

Some MMs are worse than others but most engage in subtle (sometimes
not so subtle) manipulative behaviors that are designed to make them
MORE money than they would normally on a stock trade. Since the
amount they can make is dependent on the spread, they sometimes do
things to keep the spread wide. In a moderate market the MM can usually
keep a nice profitable spread for himself. If volume starts
running the spread usually tightens up and the MMs make their money
based more on the overall volume of trades. If volume is weak, you
might see
a wide spread so the MM can at least make it worth his while to pay
attention and conduct the trades (not always the reason for wide spread
but that’s another story).

There are often circumstances that allow an MM so inclined, to try
and induce certain movements in the markets they keep. Just like we see
opportunities in the markets we play, they have opportunities also.
When the situation allows, they will attempt to make certain “plays”.
One is called a “shakeout”. A shakeout usually occurs after a stock
(particualrly an OTC/BB) has had a meteoric rise. MMs may have either
sold short on the way up and at the run’s peaks and/or sold naked
shorts or want to stock up down low due to expected demand. This
situation creates a large demand amongst one or more MMs to buy shares,
preferably at a low price…the shakeout begins.

It usually starts with one or two MMs that try to “walk” the price
down by stomping on an ask price. By stomping on an ask price I mean
the MMs will take the best ask position (offering the stock at the
price) and even in the face of heavy BUYING, they won’t move the ask
up, in fact many times they lower their ask right in the face of heavy
buying! Would you lower YOUR selling price in the face of high demand?
I wouldn’t. But to the MM playing this game, it doesn’t matter.Its just
a cost of doing business to them.
Suppose an MM has little or no inventory in the stock and the huge
demand caught them off guard, they “sold some shares short” at various
levels using virtual inventory (shares they didn’t have in customer
inventory). They have three days to settle so they need to buy back
some shares to cover their naked short sells or be subject to punitive
action, hopefully for them they can pick them up very cheaply
and make a lot of money.

One way to do this is to induce a shakeout. Keep in mind, stocks that
have had huge mega runs in just a few days tend to have a lot of
“non-investor” types such as daytraders, momentum traders, position
players etc. in them. These types are “weak” shareholders, that won’t
hesitate to sell, sometimes at the slightest indication of a slowdown
on a profit taking dip. By stomping on the ask and walking it down by
lowering their selling price, they also drive the bid down. In the most
blatant cases , you’ll often see the ask lines cross
red over the bid lines on level II real time as the manipulator lowers
his selling price to levels even lower than what people have been
eagerly bidding for it!

It usually isn’t long before the weakest hands start to join in the
selling thinking that the party is over. This in turn induces more
selling and in the best cases for MMs, “panic selling” occurs.The price plunges to support levels which is an indication of
how many longs, and investors are in a stock. The MMs are usually aware
when the market bottoms out. Sometimes an MM or two tries to go lower
but if there is adequate support, the stock will cease declining and
quickly move back up as shorts are covered, inventories replenished and
longs and daytraders buymore or buy back. Depending on several factors
it may or may not rise back to and beyond the daily high.If it does,
that is very bullish short term. Either way the MMs made out big time.
Those that were shorting at the top covered and made mad cash, the
others that didn’t actively “play” the game just let it happend and
made mad cash on the spread over the volume created by the activity.
From a T/A standpoint, after a shakeout, where the levels of support
and resistance are established is the best indication of where
the stock may go next.

What is a Margin? Margin allows investors to buy securities, by borrowing money from a broker. The margin is the difference between the market value of a stock at the time of its purchase and the funds available in the account.*Margin Account: A leveragable account in which stocks can be purchased for a combination of cash and a loan. The loan in the margin account is collateralized by the stock and, if the value of the stock drops sufficiently, the owner will be asked to either put in more cash, or sell a portion of the stock. Margin rules are federally regulated, but margin requirements and interest may vary among brokers/dealers.*Margin Call: A demand for additional funds, because of adverse price movement. Margin maintenance is a demand for additional funds to bring the account into good standing.*Margin Rates: Interest rate charged on a margin account is different from one broker to the next. The rate is typically tied to the Prime Interest Rate. The rates presently range from 6.5% to 10%. Discount Brokers are typically at lower end of the range, while full service brokers are closer to the upper end of the range. For purposes of our discussion, we assume an inflation rate of 4.5%.
*With a margin account, an investor is allowed to borrow money from his/her broker, in order to increase purchasing power. This is a great idea, if one can manage one’s account in a responsible manner. It’s just like having a credit card. If you know how to manage your spending habits, a credit card is a great convenience. If you don’t, a credit card is a recipe for disaster. A margin account should be viewed in the same way. An investor who manages his/her investment habits wisely can benefit handsomely from a margin account. Otherwise, operating on margin can be quite dangerous. Let’s take a look at some examples to demonstrate the point.

Long Term Investing using Margins: If you are a long term investor, does it make sense to use margin? Well, that depends on how disciplined you are. If you invest in Internet stocks, using margin is a sure way to get a margin call from your broker and most likely get blown out of your position. If you are a conservative investor, most likely you do not use a margin account. If you do, however, and you invest in a stock that has a very low rate of return (less than margin rate) you will lose money. Remember, when buying on margin the return on your investment must be higher than the margin interest rate that your broker is charging you. The following example is a good way to invest for the long term, using margin.

Example 1:

In this case, an investor can borrow money from his broker at an interest rate of 7%. Let’s assume that he deposited $10,000 in his brokerage account, 10 years ago. We want to calculate the rate of return on his investment given a Cash Account and given a Margin Account. We assume that this investor has put his money into shares of McDonald’s Corporation (MCD). This stock is one of the 30 securities in the Dow Jones Industrial Average. In February of 1989, shares of MCD were trading at $12 1/2. (This takes into account the two intervening stock splits.) Historically, this company has paid about $0.39 per share in form of dividends. For our purposes, we will not consider the dividend in our calculations. Neither will we consider tax consequences. Our investor could have purchased 800 shares of MCD in February 1989. In February of 1999 those shares would be worth (800 x $81 = $64,800). The rate of return of this investment is:

Rate of Return = % x (Portfolio Value at time t – Portfolio Value at start)/Original Money Invested

Rate of Return = 100% x (64,800 – 10,000)/10,000 = 548% which is equal to an Annualized Rate of Return of 20.55%

Now let’s assume that our investor has used margin to increase his purchasing power. He is paying 7% in interest on his margin balance. Our investor is prudent and is setting aside the interest on the margin balance. If he borrows $9,000 from his broker, then the monthly interest payment on the $9,000 is:

Monthly Interest Payment = ($9,000 x 7% x 1/12) = $52.50

His Purchasing Power = $10,000 + $9,000 = $19,000. Assume that he gives himself a $1,000 cushion, in case of a market sell off.

Our investor will only invest $18,000 and saves the other $1,000 to pay off the monthly interest on his account. Thus, our investor has the power to purchase 1,440 shares of McDonalds ( $18,000 / 12.50). One year later, in February 1990, shares of MCD were selling for $16.25. Our investor’s assets were worth $14,770 = (16.25 x 1,440 = 23,400) + 1,000 – 9,000 (borrowed money) – $630 (interest paid)). Note that our investor only owes $9,000 to his broker and he can easily sell enough shares to payoff his debt. Let’s assume, however, that he does not. The following table summarizes calculations for the ten year period:

Date*No. of SharesShare PricesValue of Shares*Annual Interest PaidMargin BalancePercent EquityPortfolio ValueColumn 1*Column 2*Col. 3Col. 4 = 2 x 3Col. 5 = Col. 6 x 7%Col. 6*Col. 7 = 8/4*Col*8 = Col 4 + cash in the acct – Col. 6 – Col. 5*Feb 89*1,440*12.50*18,000.000*9,000*55.6%*10,000*Feb 90*1,440*16.25*23,400.006309,000*63.1%*14,770*Feb 91*1,440*15.75*22,680.00630*9,000*60.3%*13,420*Feb 92*1,440*22.13*31,867.206309,00059.2%**21,607.20*F eb 93*1,440*25.00*36,000.006309,52071.8%*25,850**Feb 94*1,440*31.00*44,640.00666.40*10,186.40*75.7%*33, 787.20**Feb 95*1,440*34.00*48,960.00713.05*10,899.40**76.3%37, 347.55**Feb 96*1,440*51.00*73,440.00762.96*11,662.36**83.1%*61 ,014.68*Feb 97*1,440*47.00*67,680.00816.37*12,478.73*80.4%*54, 384.90**Feb 98*1,440*52.00*74,880.00873.51*13,352.24*81%*60,65 4.25**Feb 99*1,440*81.00*116,640.00934.66*14,286.90**87.0%10 1,418.44*

The above example shows that wise use of margin buying can significantly increase return on investment. By not using Margin, out investor’s return on the McDonald’s investment was 548%. Using Margin, the return was 914.2%. To simplify, our investor had a return of 20.55% on his own $10,000 and 13.55% (20.55% – 7% (margin rate)) return on the money that he borrowed from his broker.

Example 2:

Regarding the issue of margin investing in volatile stocks: We will see whether an investor can beat a rapidly changing market. He wants to maximize his return. This investor had $10,000 and he wanted to get the biggest bang for his money. He invested in Internet stocks, since he heard that these stocks can gain as much as $40 to $50 per day. The example involves the stock of ONSALE (ONSL). We mean nothing negative about the company, by the way, but the volatility of the stock allows us to make a point. Our investor, bought $20,000 worth of ONSALE, or 250 shares, on November 27, 1998. The price was $80 per share. He was so sure that the stock was heading higher that he left no room for error. Share prices over the following 10 days are shown below, to illustrate how our investor got a margin call and was subsequently blown out of his position. He was forced to sell his shares on 12/2/98, at $58. The loss was significant. His portfolio’s value on 12/2/98 was reduced to $5,465.25. It sure was a sucker game for this inexperienced investor.

1. Never invest in volatile stocks on margin.

2. Never max out on margin. Always leave room for error and market volatility.

3. Always leave a minimum of 20-25% on your margin buying power as room for error.

4. If investing on margin, always invest in solid and blue chip stocks or S&P 500 Index Funds.

5. Never attempt to beat the market. You will fail. You may get lucky once but do not push your luck.

6. Despite common belief, the best way to make money on margin is to invest long term.

7. Do not think of the margin fund as your brokers money. It is yours. Remember that rules and regulations are written to protect your broker. Do not get creative about margin accounts.

8. If you short sell, you must have a margin account. Short sell only if you fully understand market timing and your risk level.