The Games That Market Makers Play
market makerstrading psychology
This is important to see which side of the inside market is being transacted against, either the best bid or best ask. Once you can determine that, you must see how the market makers are positioning themselves in response to those transactions.
If the majority of transactions are going off at the best bid and market makers are not refreshing their quotes at that level (which will be indicated by a shrinking number of market makers on the inside bid), the price is headed down. If the transactions are against the best bid, but the market makers are refreshing their prices, or more market makers are joining the best bid, then there is real support at that level and an uptick can be expected.
A comparable situation is true if transactions are going off at the best ask. This means that traders have an appetite for that security. If the market makers try to get out of their way by reducing their numbers on the best ask, you can bet the stock is going up. If the market makers stay and refresh their prices, you can say the buying pressure will likely subside and the price will fall.
The analysis you should perform is not just to look at it at any one point in time and see that there are more market makers on one side than the other. It is the flow and how the market makers react to transactions that gives you information.
Market makers know that traders use this information in their trading decision process and can use that to their advantage. There are occasions when a market maker may want to buy, but will post a large size on the ask side of the market to scare purchasers away, or shake out holders of the security. Market makers have anonymous routes, like Instinet (INCA), as well as the ECNs, like Island and Archipelago, with which to disguise their intentions.
There is one time of day, though, that the market makers do not tend to play so many games with the prices they advertise, and that is at market open. During this time, there is so much volume being transacted that advertising fake bids or asks to move the activity in the market is too dangerous. During the high volume open, the prices advertised by market makers tend to give a true indication of their intentions.
Although it is difficult to get a feel from the time-of-sales screen for whether the bids or asks are getting transacted against, you can take the market maker actions as information enough to make trading decisions. Past the market open, the volume subsides and the games really begin. There are manuals available that show examples of market makers using Instinet to hide their actions, and that urge you to try to spot market makers hiding their intentions so that you can take positions in harmony with them. This is a fine goal, but it is not realistic. Think about it.
Market makers are given orders by large institutions to get the best price. If a market maker shows his hand consistently enough for traders in the market to observe his actions and take advantage of them, he is moving the market against the interests of his client. Ultimately, this will lead to the market maker going out of business, because he will not get orders from the better institutions. If he is not in business, he is not there for you to follow his actions. This means that the only market makers left out there are the good ones who can fill an order without adversely affecting the market.
A popular description of the „chief“ market maker in a security is the Axe. The Axe market maker is the one who gets all the big orders from institutions and drives the price of the security either up or down—or so perceived wisdom would suggest. It is not a difficult thing to look up trading data and see which market maker transacts the most volume for a security that you are interested in. Those who try to follow the Axe believe that a trend will start when a large order from an institution is placed with that market maker. The trader's goal is then to spot the Axe accumulating stock and follow his actions. If you attempt to do this, you are likely to overtrade and take many losing positions.
To balance their positions (and from which to take the spread), market makers have the benefit of orders coming in to them. They have enormous capital and higher leverage available than the individual trader. If you try to play their game with them, the most likely outcome is that they will win and you will lose.
