Market Maker Speaks Out - Ways of a MM (Market Maker)
By and large most MM don't have a clue nor do they care to learn, about the
fundamentals of the stocks they trade.
They just try to make orderly markets. When dealing with BB stocks it is very
easy for a MM to get trapped into being short in dealing in a fast moving
market. Reason being; most of the MM's in this stock are what are called
"wholesalers" this means they don't have retail brokers "working" the stocks.
So they have to rely on what's known as the "call" from larger retail houses.
If a "Big" retail firm like an E-trade calls up a market maker to purchase
say 5,000 shares of a stock, they expect to get an "execution" from that
market maker. If he turns them down, or only gives a partial then the "Big"
firm will go to another MM.
If this second MM "fills the order" then that "Big" firm has a moral
obligation to continue to give future "business" in that stock to that MM who
preformed (his life blood). This will go on until he "fails" to perform and
so on.
Contrary to popular opinion the "Big" firms Do NOT necessarily go to the "Low
Offer" to fill a buy order (Or high bid for a sell). The "Go" to who they
think will perform to fill the order and expect that MM to "match" the "low
offer" in the case of a buy (bid in the case of a sell). Even though this MM
might in fact be the "high bid" and not really want to sell any more.
As a wholesaler he must perform or he will get a reputation as a
"non-performer" with the "Big" houses and will cease getting "calls" which
means he will soon go out of business. I mentioned above that this activity
is very significant to BB stocks. I say this because most of the trades in
these BB stocks are "unsolicited" and are done through discount houses, ergo
"Big" firms.
With the above groundwork laid, let me try to explain how market makers get
short even if they like the Company; Lets say that a stock (shell) has been
lying quietly at $.25 bid $.50 offered. A limit order comes into one of the
MM's to Buy at $.50 for a thousand shares. Prior to this trade that MM may be
"flat" (neither long or short any shares). He fill the order and is now short
1,000 shares. He may raise his bid hoping to find a seller to "flatten" out
his position. But before he realizes it a wave of buyers have come in and
cleared out all the $.50 offers. Now the stock is $.50 bid .75 offered. Here
comes that "Big" firm he just sold the 1,000 shares to at .50 with another
bid for 1000 at .75. He makes this print. Now he is short 2,000 at an average
of .625. The market keeps moving and now its .75 bid 1.00 offered. Now he has
to make a decision.
Just like investors, MM Hate to take a loss. So 9 times out of 10 he will now
sell 2000 at 1.00 making him short 4000 but with an average .81. At this time
he would love to see a seller at .75 so he can cover his short and make a few
bucks.
But instead the market keeps moving up. Now it is 1.00 to 1.25 and here comes
the buyer again at 1.25. He doesn't want to loose the call so now he needs to
sell 4,000 at 1.25 to keep his break even point above the bid. Now he is
short 8,000. Market moves up to 1.25 bid 1.50 offer here comes the buyer now
he feels he must sell 8000 here because "stocks don't go up forever".
Now he is short 16,000. And so on and so on. If the stock keeps moving up,
before he realizes it he could be short 50k or 100k shares (depending how big
his bank is).
Finally the market closes for the day and on paper he may look allright in
that his "break even" price may be around the closing price. But now he has
to figure out how to entice sellers so he can cover this short. It is
important to note that if this happened to one MM it has probably happened to
most all of them.
Some ways MM's entice sellers; Run the stock up with a "tight spread" in a
fast market, then "open" up the spread to slow down the buying interest.
After it has "cooled off" for a little while lower the offer below the last
trade right after a small piece trades on the offer then tighten the spread
so that the sellers feel they can take a "quick profit" by "hitting the bid"
on the tight spread.
Once the selling starts the MM's will walk it down quickly by only making
small prints on the way down with the tight spread. Another way is by running
the stock up in the morning, averaging up their short then use the above
technique to walk it down in the afternoon.
Hopefully after doing this for several days, it will demoralize the buyers.
The volume will dry up and the sellers will materialize thinking that the
game is over.
Contrary to popular opinion, MM usually Do Not Cover in Fast moving markets
either Up or Down if they are short. They Short More. They usually try to
cover after the frenzy is out of the market. There are many other techniques
they use but the above are the most popular.
This technique works about 9 times out of 10 particularly in a BB market.
However that is because 9 out of 10 BB stocks are BS. Remember what I said
above. Most MM's don't have a clue as to the value of a Company until they
get trapped. If the Company has solid fundamentals and a bright future. Then
the stock will do very well. And the activity that caused the situation will
prove to even help the future stock activity because it created an audience."
Market makers start their mornings between 8:30 and 9:00 a.m.ET making a
guess at where a stock will open. To set the price, they check to see if
there's any news (positive or negative) from the day before that should
affect the stock. They also check to see: 1) if there are a lot of buy or
sell orders waiting in the queue for the stock; 2) how a stock is trading in
overseas markets; and 3) how a stock traded in after-hours trading.
A few minutes before the market opens, the market makers start to adjust
their bid and ask prices to make sure that they are in sync with their peers.
The key for a market maker is to never take his/her eye off of the other
quotes that exist for a stock because if his stock is incorrectly priced, he
could lose his shorts (so to speak).
EXAMPLE: Let's say market maker A has a bid/ask of $7.25/$7.50. That means
that the stock can be sold for $7.25 to that market maker and bought from the
market maker for $7.50. Meanwhile, market maker B posts a bid/ask of
$8/$8.25. Traders would quickly buy stock from A at $7.50 and sell it right
away to B at $8 -- A $0.50 profit on each share.
So can the bid/ask prices change from one market order to the next? Yes.
Market makers are constantly adjusting their prices, often doing so several
times between trades. They are jockeying for position against one another in
order to be best-positioned to trade their stocks at a profit. As a result,
they are more likely to adjust their bid/ask prices in response to each
other, rather than in response to orders that are coming in from customers.
Is there anything you can do to predict where a stock will open? Not really.
But you can get a sense of whether a stock will open up or down by looking
for positive or negative news on a company, how the company is trading in
overseas markets and what happened to it overnight in Instinet trading.
===================================
Market Makers (MMs), particularly in the OTC/BB market, have a number
of "methods" they can use to help them make more money. Acting within
their "official" capacity MMs are supposed to keep a liquid and
balanced market by regulating the incoming buys and sells. Their goal
is to facilitate trading in particular stocks by utilizing a quotation
network to
post incoming trades and also trades for their own accounts. They trade
amongst each other and a balance is found naturally based on supply and
demand. The spread represents the difference between current
top bid for a stock and the ask which is the minimum the holders are
willing to sell for. Various Market Makers have inventory in the stock
you want to buy from people that sold for their bid price, and because
you buy at the more expensive "ask" price (or thereabouts) the MM's are
able to pocket the difference for their trouble.
Some MMs are worse than others but most engage in subtle (sometimes
not so subtle) manipulative behaviors that are designed to make them
MORE money than they would normally on a stock trade. Since the
amount they can make is dependent on the spread, they sometimes do
things to keep the spread wide. In a moderate market the MM can usually
keep a nice profitable spread for himself. If volume starts
running the spread usually tightens up and the MMs make their money
based more on the overall volume of trades. If volume is weak, you
might see
a wide spread so the MM can at least make it worth his while to pay
attention and conduct the trades (not always the reason for wide spread
but that's another story).
There are often circumstances that allow an MM so inclined, to try
and induce certain movements in the markets they keep. Just like we see
opportunities in the markets we play, they have opportunities also.
When the situation allows, they will attempt to make certain "plays".
One is called a "shakeout". A shakeout usually occurs after a stock
(particularly an OTC/BB) has had a meteoric rise. MMs may have either
sold short on the way up and at the run's peaks and/or sold naked
shorts or want to stock up down low due to expected demand. This
situation creates a large demand amongst one or more MMs to buy shares,
preferably at a low price...the shakeout begins.
It usually starts with one or two MMs that try to "walk" the price
down by stomping on an ask price. By stomping on an ask price I mean
the MMs will take the best ask position (offering the stock at the
lowest
price) and even in the face of heavy BUYING, they won't move the ask
up, in fact many times they lower their ask right in the face of heavy
buying! Would you lower YOUR selling price in the face of high demand?
I wouldn't. But to the MM playing this game, it doesn't matter. Its just
a cost of doing business to them.
Suppose an MM has little or no inventory in the stock and the huge
demand caught them off guard, they "sold some shares short" at various
levels using virtual inventory (shares they didn't have in customer
inventory). They have three days to settle so they need to buy back
some shares to cover their naked short sells or be subject to punitive
action, hopefully for them they can pick them up very cheaply
and make a lot of money.
One way to do this is to induce a shakeout. Keep in mind, stocks that
have had huge mega runs in just a few days tend to have a lot of
"non-investor" types such as daytraders, momentum traders, position
players etc. in them. These types are "weak" shareholders, that won't
hesitate to sell, sometimes at the slightest indication of a slowdown
or
on a profit taking dip. By stomping on the ask and walking it down by
lowering their selling price, they also drive the bid down. In the most
blatant cases , you'll often see the ask lines cross
red over the bid lines on level II real time as the manipulator lowers
his selling price to levels even lower than what people have been
eagerly bidding for it!
It usually isn't long before the weakest hands start to join in the
selling thinking that the party is over. This in turn induces more
selling and in the best cases for MMs, "panic selling" occurs. The price
plunges to support levels which is an indication of
how many longs, and investors are in a stock. The MMs are usually aware
when the market bottoms out. Sometimes an MM or two tries to go lower
but if there is adequate support, the stock will cease declining and
quickly move back up as shorts are covered, inventories replenished and
longs and daytraders buy more or buy back. Depending on several factors
it may or may not rise back to and beyond the daily high. If it does,
that is very bullish short term. Either way the MMs made out big time.
Those that were shorting at the top covered and made mad cash, the
others that didn't actively "play" the game just let it happened and
made mad cash on the spread over the volume created by the activity.
From a T/A standpoint, after a shakeout, where the levels of support
and resistance are established is the best indication of where
the stock may go next.
===============================
What is a Margin? Margin allows investors to buy securities, by borrowing
money from a broker. The margin is the difference between the market value of
a stock at the time of its purchase and the funds available in the
account. Margin Account: A leveragable account in which stocks can be
purchased for a combination of cash and a loan. The loan in the margin
account is collateralized by the stock and, if the value of the stock drops
sufficiently, the owner will be asked to either put in more cash, or sell a
portion of the stock. Margin rules are federally regulated, but margin
requirements and interest may vary among brokers/dealers. Margin Call: A
demand for additional funds, because of adverse price movement. Margin
maintenance is a demand for additional funds to bring the account into good
standing. Margin Rates: Interest rate charged on a margin account is
different from one broker to the next. The rate is typically tied to the
Prime Interest Rate. The rates presently range from 6.5% to 10%. Discount
Brokers are typically at lower end of the range, while full service brokers
are closer to the upper end of the range. For purposes of our discussion, we
assume an inflation rate of 4.5%.
With a margin account, an investor is allowed to borrow money from his/her
broker, in order to increase purchasing power. This is a great idea, if one
can manage one's account in a responsible manner. It's just like having a
credit card. If you know how to manage your spending habits, a credit card is
a great convenience. If you don't, a credit card is a recipe for disaster. A
margin account should be viewed in the same way. An investor who manages
his/her investment habits wisely can benefit handsomely from a margin
account. Otherwise, operating on margin can be quite dangerous. Let's take a
look at some examples to demonstrate the point.
Long Term Investing using Margins: If you are a long term investor, does it
make sense to use margin? Well, that depends on how disciplined you are. If
you invest in Internet stocks, using margin is a sure way to get a margin
call from your broker and most likely get blown out of your position. If you
are a conservative investor, most likely you do not use a margin account. If
you do, however, and you invest in a stock that has a very low rate of return
(less than margin rate) you will lose money. Remember, when buying on margin
the return on your investment must be higher than the margin interest rate
that your broker is charging you. The following example is a good way to
invest for the long term, using margin.
Example 1:
In this case, an investor can borrow money from his broker at an interest
rate of 7%. Let's assume that he deposited $10,000 in his brokerage account,
10 years ago. We want to calculate the rate of return on his investment given
a Cash Account and given a Margin Account. We assume that this investor has
put his money into shares of McDonald's Corporation (MCD). This stock is one
of the 30 securities in the Dow Jones Industrial Average. In February of
1989, shares of MCD were trading at $12 1/2. (This takes into account the two
intervening stock splits.) Historically, this company has paid about $0.39
per share in form of dividends. For our purposes, we will not consider the
dividend in our calculations. Neither will we consider tax consequences. Our
investor could have purchased 800 shares of MCD in February 1989. In February
of 1999 those shares would be worth (800 x $81 = $64,800). The rate of return
of this investment is:
Rate of Return = % x (Portfolio Value at time t - Portfolio Value at
start)/Original Money Invested
Rate of Return = 100% x (64,800 - 10,000)/10,000 = 548% which is equal to an
Annualized Rate of Return of 20.55%
Now let's assume that our investor has used margin to increase his purchasing
power. He is paying 7% in interest on his margin balance. Our investor is
prudent and is setting aside the interest on the margin balance. If he
borrows $9,000 from his broker, then the monthly interest payment on the
$9,000 is:
Monthly Interest Payment = ($9,000 x 7% x 1/12) = $52.50
His Purchasing Power = $10,000 + $9,000 = $19,000. Assume that he gives
himself a $1,000 cushion, in case of a market sell off.
Our investor will only invest $18,000 and saves the other $1,000 to pay off
the monthly interest on his account. Thus, our investor has the power to
purchase 1,440 shares of McDonalds ( $18,000 / 12.50). One year later, in
February 1990, shares of MCD were selling for $16.25. Our investor's assets
were worth $14,770 = (16.25 x 1,440 = 23,400) + 1,000 - 9,000 (borrowed
money) - $630 (interest paid)). Note that our investor only owes $9,000 to
his broker and he can easily sell enough shares to payoff his debt. Let's
assume, however, that he does not. The following table summarizes
calculations for the ten year period:
Date No. of Shares Share Prices Value of Shares Annual Interest Paid Margin
Balance Percent Equity Portfolio Value Column 1 Column 2 Col. 3Col. 4 = 2 x
3Col. 5 = Col. 6 x 7%Col. 6 Col. 7 = 8/4 Col 8 = Col 4 + cash in the acct -
Col. 6 - Col. 5 Feb 89 1,440 12.50 18,000.000 9,000 55.6% 10,000 Feb
90 1,440 16.25 23,400.006309,000 63.1% 14,770 Feb
91 1,440 15.75 22,680.00630 9,000 60.3% 13,420 Feb
92 1,440 22.13 31,867.206309,00059.2% 21,607.20 Feb
93 1,440 25.00 36,000.006309,52071.8% 25,850 Feb
94 1,440 31.00 44,640.00666.40 10,186.40 75.7% 33,787.20 Feb
95 1,440 34.00 48,960.00713.05 10,899.40 76.3%37,347.55 Feb
96 1,440 51.00 73,440.00762.96 11,662.36 83.1% 61,014.68 Feb
97 1,440 47.00 67,680.00816.37 12,478.73 80.4% 54,384.90 Feb
98 1,440 52.00 74,880.00873.51 13,352.24 81% 60,654.25 Feb
99 1,440 81.00 116,640.00934.66 14,286.90 87.0%101,418.44
The above example shows that wise use of margin buying can significantly
increase return on investment. By not using Margin, out investor's return on
the McDonald's investment was 548%. Using Margin, the return was 914.2%. To
simplify, our investor had a return of 20.55% on his own $10,000 and 13.55%
(20.55% - 7% (margin rate)) return on the money that he borrowed from his
broker.
Example 2:
Regarding the issue of margin investing in volatile stocks: We will see
whether an investor can beat a rapidly changing market. He wants to maximize
his return. This investor had $10,000 and he wanted to get the biggest bang
for his money. He invested in Internet stocks, since he heard that these
stocks can gain as much as $40 to $50 per day. The example involves the stock
of ONSALE (ONSL). We mean nothing negative about the company, by the way, but
the volatility of the stock allows us to make a point. Our investor, bought
$20,000 worth of ONSALE, or 250 shares, on November 27, 1998. The price was
$80 per share. He was so sure that the stock was heading higher that he left
no room for error. Share prices over the following 10 days are shown below,
to illustrate how our investor got a margin call and was subsequently blown
out of his position. He was forced to sell his shares on 12/2/98, at $58. The
loss was significant. His portfolio's value on 12/2/98 was reduced to
$5,465.25. It sure was a sucker game for this inexperienced investor.
1. Never invest in volatile stocks on margin.
2. Never max out on margin. Always leave room for error and market volatility.
3. Always leave a minimum of 20-25% on your margin buying power as room for
error.
4. If investing on margin, always invest in solid and blue chip stocks or S&P
500 Index Funds.
5. Never attempt to beat the market. You will fail. You may get lucky once
but do not push your luck.
6. Despite common belief, the best way to make money on margin is to invest
long term.
7. Do not think of the margin fund as your brokers money. It is yours.
Remember that rules and regulations are written to protect your broker. Do
not get creative about margin accounts.
8. If you short sell, you must have a margin account. Short sell only if you
fully understand market timing and your risk level.
=================
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