Tricks of the Market Makers

On the London Stock Exchange (LSE) there are Market Makers for many smaller companies and less heavily traded shares. Market Makers are financial institutions who have agreed with their clients (the quoted company) and who have been approved by regulators to “make a market” in the shares of the client. Their role is to guarantee a market in a particular share so that investors can buy and sell easily i.e. they make a lightly traded share more liquid. They in effect assume some risk in return for the chance of the profit on the spread by acting as the middleman. Each stock always has at least two market makers and they are obliged to deal. Even if no other trader on the other side of the trade at a particular time, market makers will guarantee to buy and sell the shares in which they make markets. They make their money through the difference between the buying and selling price, the so called bid-offer spread. The bid price for a stock is the price at which the market maker is currently willing to buy, or is bidding for, shares. The ask price is where the market maker is currently willing to sell, or is asking for, shares. The bid price is always lower than the ask price so the market maker can make money on the spread.

Market Makers are not supposed to allow themselves to go short, but in process of making a market they may well find themselves short of a stock. If this situation they can purchase from another Market Maker, move the price to get the shares from sellers of the stock or borrow the shares from an institutional investor. Therefore a market maker can make money in both rising or falling markets, as long as they correctly predict which way a stock's price will move. The more actively a share is traded the more money a Market Maker makes so they will try and encourage trading of a particular stock by moving the price up or down to bring buyers or sellers into a market.

Some tricks of the Market Makers

1. An institution places a big order for a stock. The market maker doesn't have enough stock to complete the transaction so he has two options 1) drop the price to trigger sales 2) increase the price to trigger sales. If the price is dropped other buyers may be tempted in and the market maker may still be short of stock and owe the institution shares it is guaranteed to provide. So sometimes for no apparent reason the stock price drops dramatically, a so called "tree shake" to trigger stop losses and allow the market maker to pick up the stock he needs. 

2. If a particular share rises dramatically on an announcement, market makers sell stock to meet these orders and sometimes they sell these buyers stock they don't actually own in anticipation that they'll able to pick up stock more cheaply in the future to meet these buy orders when the share price reverses down. By gathering shares at a lower price they can meet the obligations of the buyers at a profit. This is why the share price can often drift down for days or week after a big announcement so that the Market Maker can guarantee that they can deliver all the shares they have promised by triggering sales.