HERE IS A GOOD READ ON MM GAMES AND HOW IT WORKS
Explanation on How the Market or Market Makers really works
To lubricate their transactions, market makers need a supply, or inventory of the securities they support. This can either be real certificates, or via a process called 'stock lending' (don't worry about THAT one yet - it basically means they borrow stock or "pretend" they have it). Once you have an inventory of stock, and the concept of 'spread' (or 'edge'), a marvelous opportunity opens up. The average price at which a market maker accumulates a security and the average price at which he distributes it are going to be different. Add this to the fact that the market maker sets the price tick by tick, and boom! A license to print money. Observe closely, this is a good trick.
Let's play Chicken
I, as a market maker, decide (for no real reason, or perhaps because there has been some trivial news about them) that stock in ABC Corp is my plaything today. I don't have much of an inventory in that particular security, so what do I do? Mark up the price so external holders will sell me some? No. I mark the price DOWN. Oof. Some external parties see this as a buying opportunity, and as I am a market maker, I am obliged to sell them the security at the new, lower price, meaning I am even shorter on that security.
Sounds mad, doesn't it? But it doesn't matter, because I mark the price down again. And again. And I keep on doing it till I hit the stops of external parties who are long, but weak, or the limit orders of people who are short. As a market maker, I know where these stops and limits are. I own the book, after all.
Ordinary Joe Public mostly think the market follows the laws of supply and demand, follows trendlines or fibonaccis etc, which means they all tend to put their stops in similar places ('resistance' anyone? 'support'? That's right, it exists!). This is a game of chicken, really, and YOU will ALWAYS crack before ME (the market maker), because I can take the market to zero, or to the moon. You have to meet a margin call.
So now I am a market maker who has a LOT of supply of ABC Corp, which has fallen significantly in price. Looks like I'm holding a plum, doesn't it? What do I do next?
So what does a market maker do?
...That's right. I mark the price up. And I QUICKLY mark it up to the point at which the current price is ABOVE my average purchase price. So voila. I'm in profit. In a fairly big way. All I need to do now is unload this stock to you over a period of time at a price above my average, and I am rich. You, of course, sold it to me on the way down, and are regretting it because it is probably already way above where you exited (strange isn't it, how the market seems to 'hunt your stops', and then reverse?!) If I do this right (and it is an art form, for which successful brokers get paid multi-million dollar salaries), I create the illusion that the market is totally random, and is being driven by YOU, whereas I am simply a fee paid middleman, facilitating your activities. Even worse, I give you the vague impression that you are actually pretty good at it, and if you can only get your stops a little more accurate, you will stop losing money!
As I mark the price up, external parties start to worry they will miss out on this growth, and begin an ABC Corp buying frenzy, allowing me to unload. Everyone is happy. Most of the investing public are sitting on unrealized (imaginary) assets, while I am converting worthless shares into hard cash.
So, I have made a real, cash profit. You are sitting on an unrealized paper profit. We are all happy. Until I repeat the process and stop you out. Again. Are you getting the picture yet? In fact, once I have built a little momentum in a particular direction (long OR short) I can let you prolong it, settling simply for my spread profit. I know that eventually the run will peter out, and then I can force it the other way, easily dislodging those who took a position too near the end of that particular phase.
Let me paraphrase. When the market is zooming up madly, market makers are actually selling (usually stock they don't own!) in preparation for a subsequent managed fall, during which they can buy it back for less (i.e. make a profit). When it is crashing down, they are actually acquiring stock, in preparation for the process of selling it back to you at a higher price (i.e. make another profit).
AI
