Function of Market Makers

Q. It is said that market makers are there to provide liquidity. Is this correct? Is providing liquidity their only job?

How can I tell if a bid-offer spread is put there by the market makers or naturally by different bidders and sellers? Do market makers execute trades with other market makers? How do market makers hedge their exposure?

A: Yes, they provide liquidity to the market. But they are there to make money as well. In fact they are there to make money WHENEVER possible, and considering the spreads they offer, it's pretty well all the time .

Think about how bookies work at the racetrack by offering odds. Market makers work in a similar way to make money, generally by pushing the buy price higher than fair value based on the current price of the underlying, and the current volatility levels, and the same for the sell price - pushing it lower.

Different market makers can be making a market for the same security, and you can find that one is offering the bid, and the other is offering the ask, with each other's side being further out than the other. This effectively reduces the spread when it happens. A lot depends on how aggressive a market maker is, and what kind of policy they adopt in terms of exposure.

It is entirely possible for one market maker to trade with another (just like a bookie does) to hedge risk. Think about a bookie that takes two bets on a 100-1 odd horse. They may make one bet with another bookie to reduce their exposure. The same is true for Market makers. They may transact with anyone in order to hedge a position. So of course, Market Makers also trade with each other. How else would they get access to liquidity when they want to Prop trade (they do this as well as performing their Market Maker job) - just a hint, most of the banks view the market making department as a way of getting their prop traders reduced exchange fees, not as a primary market making department. As for your second question Market Makers are the ones trading in round lot numbers, so if you look at the spread, and 10 on the bid and 10 on the ask, it's quite possibly a Market Maker.

The market maker's aim is to make as much margin on each transaction as possible - if you are offering a trade which hedges another trade on the opposite side, you may get set around fair value or better, especially if there is a lot of activity on the other side of the market (i.e. you're entering bullishly while the majority are taking a bearish view). But if you're exiting on a stop, and they see you coming, they may widen the spread, or skew it as people get shaken out of positions. This is partly how they can maximise their profits.

If you jiggle your order up and down, they'll smell an amateur if their operator is awake, and they may play spread games with you widening the spread, enticing you to enter at a less favourable level, even if the underlying does nothing at all. Beware of this; this is a standard market maker trick. I found you really have to have an approach in mind (almost a preconceived tactic) based on your view of the underlying and what it will do.

A lot depends on the strategy you are entering/exiting, and the time frame you have in mind, and the level of profit you are looking for. If you're scalping, this is radically different to position trading. I'm a position trader, so my style is not suitable for a scalper/intra-day trader.

As much as every trader will slag off those 'devious MMs' a number of times in a day/month/year (depending on your style of trading), this is probably going to be comparable to the number of complaints about the lack of liquidity on a series you would otherwise have traded - and MMs do provide liquidity as a function of their role.

Try not to hold a grudge, otherwise it could find expression in another trade and don't get too distracted by what the other half is doing. Take the emotion out of the process, and focus on what is going on, and success is more likely to find you!

 ...Continues here - How Interest Rates affect the Prices of Stocks

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