Understanding Market Makers
Market makers play a big role in over the counter markets like the OTC-BB and Pinksheets. Often times, there is not a lot of liquidity and trading volume in these markets, which creates a need for market makers to step in and create a trading environment.
What are Market Makers?
A market marker can be an individual or firm whose function is to help make a market for a security, by making bids and offers for their account in the absence of public buy or sell orders. These moves are designed to ensure that market transactions are as smooth and continuous as possible, removing any sudden surges and ditches due to buying and selling imbalances.
Unlike the NYSE’s specialist system, the Nasdaq OTC market passes orders from one market maker to another. These market makers compete with one another to buy or sell stocks to investors by displaying quotes and are obligated to buy and sell at their displayed bids and offers. They profit just like a book maker in Vegas by taking advantage of the bid and ask spreads.
Market makers regulate risk by increasing the spread between the bid and ask prices. When a security exhibits extreme volatility, market makers will increase the spread to give themselves a wider margin for error. Conversely, the spread is narrowed as demand increases and competition between market makers heats up for business.
How to Watch Market Makers
Some investors try and profit from the motives of market makers. Sometimes, market makers will post an attractive price but with a limited number of shares. The result may be an investor that puts in a large order and gets it filled at less-attractive prices. Conversely, market makers may put in large “phantom orders” – never intended for execution – to create psychological resistance levels.
A Final Word on Market Makers
Contrary to popular opinion, being a market maker isn’t a license to print money. Market makers face several risks by being required to buy and sell at bid and ask prices.Often times, market makers lessen these risks by hedging their positions through short selling and swap agreements. These efforts can sometimes be misconstrued by individual investors to be “market manipulation”.
