another good article, Market maker or market manipulator
by Darren Winters
We refer to market manipulation in our opening article and refer to our own experiences and research in this area. Whilst market makers are often referred to as manipulators, this is normally done so by traders who have lost money and have become emotional. From our research it is not the market makers that are the culprits of manipulation, just the tool!
THE MARKET MAKER
The market makers are usually large banking organisations such as Rothschild, Citigroup, J.P Morgan, Bear Stearns etc. Their role is 'make a market' in the shares of one of their clients. What we mean by this is, to ensure that there is always a market so that investors can buy and sell the shares of their clients. For example; -
If you imagine that a listed company has hundreds of thousands of shares distributed amongst thousands of shareholders. If somebody wants to buy or sell shares they need a central figure through which to trade. Firstly they will normally approach their broker who in turn will contact a market maker who deals in those particular shares.
A single market maker normally only trades in a relatively few number of companies. They have a contract with each of their clients. The company that appoints market makers will keep the number of official market makers to a minimum.
It is a widely viewed misconception that market makers set the price of the shares. In fact the price is actually set by simple supply and demand. The market maker only tells the brokers what it is, based on the demand, or lack of demand.
In reality the price they may quote may be too high for those that want to buy and they may not have any buyers, conversely they may encourage too many sellers from who they have to take the shares subject to certain criteria. They do not want to be left with a miss-balance of shares or they may end up holding more than a small float, which could leave them significantly out of pocket. They simply want to match buyers and sellers.
Their role for their client is to keep the shares as liquid as possible. The client may wish to increase the number of shares in the market at some time in the future, this may not be so easy if the shares are rarely traded.
HOW DO THEY MAKE THEIR MONEY
The market maker has to ensure they make a profit from their dealings of matching buyers with sellers. They do this from the spread between the bid and offer prices.
If a stock is particularly volatile, the market maker will increase the spread to safeguard their own position. This takes out more of the day traders who do not want to risk such wide spreads, as to make a profit between buying and selling, the stock will have to move a significant amount.
This answers why high volume stocks such as Vodafone have smaller spreads versus lower volume stocks. For example on a normal day's trading the Vodafone spread was 0.25p with volume of 104 million shares whilst Antofagasta had a spread of 11p on 400 thousand shares.
THE MARKET MAKERS OBLIGATIONS
To ensure that the markets remain liquid, once the market maker has quoted a price to buy or sell shares then they are obligated to either take or deliver those shares to/from the broker. That is being subject to the Normal Market Size (NMS). This varies subject to the volume of shares traded, thus on a company such as Vodafone this may be 200,000 shares whereas a company with less daily volume may have a NMS of 50,000 shares. Any share beyond these levels may be offered a price that reflects the change in the market. They must also always give you a price.
They also have to post their transactions, although subject to the size of the order it can be delayed to avoid either panic or rushes from smaller investors trying to keep up with larger institutional orders.
BUT DO THEY MANIPULATE THE MARKET?
There are some that say they manipulate the market as they alter the price before the market opens. Realistically as already explained they have to match buyers and sellers. Therefore if there is some significant news announced after the bell, they might adjust the opening prices to take this into account.
They may also do this after the Sunday papers have provided their tips on buys and sells. This answers why the stock price may rise then fall after a tip has been given and profits are often made by shorting the stock at its artificially high price. In both these cases they are only paring supply and demand by using price as a regulator.
Should institutional buyers give a market maker a large order and if there are too few shares available from sellers, they have been known to momentarily drop the price to encourage people to sell. This often causes investors stops to be taken out thus more shares become available. They are thus able to fulfil the order at a reasonable rate for their institutional buyer. This is known as shaking the tree and whilst not good for those with the close stops it ensures liquidity in the stock which is one of the market makers main roles and by many may be likened to management rather than manipulation, sort of!!!
A marker maker aims never to hold too many shares in any of the stocks they make the market in, as if there was a market crash they could find themselves severely financially embarrassed, as in the case of Nick Leeson and Barings!
Regards Darren Winters
