No doubt you’ve heard the financial media blame “market-makers” for everything from an individual stock’s slide to fluctuating currency rates to a sudden surge in options trading. Let’s look at just how much power these market-makers have in the stock, currency and options arenas, and what you can do to counteract their influence.
Stocks range in popularity from highly liquid, blue chip names to sparsely traded, emerging companies. Every major exchange has designated (also called primary) market-makers, which act as go-betweens. Similar to banks with currency, they buy from you at the “bid” price and sell to you at the “ask” price.
Each market-maker must provide reasonable bid/ask spreads and trade up to a maximum number of shares per day, meaning they are required to create the market for the stock with the understanding that they have immense but ultimately limited financial resources. This deters frenzied trading and helps to stabilize volatility.
There are usually several market-makers per stock, some who supply multiple exchanges. Not every trade has to work through a market-maker, but they are there to ensure that an orderly and reasonably liquid market exists even if there is lopsided buying or selling, like we saw during the recent correction.
If the bid/ask on a particular stock is large, that typically means that the market-maker expects very little volume or that the stock’s price is highly volatile. Market-makers, incidentally, “see” your hard stop levels because they have access to all of your broker’s data, which is why, if you can maintain a system, it is best to keep “mental” stop losses to ward off the effects of opportunistic market-makers.
Currencies offer the most liquid trades, usually trading more than 10 times the total of domestic stocks daily. Exchanges facilitate these trades, with retail (and some institutional) orders placed via brokers.
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Generally speaking, there is a counter-party to every trade, which means that for every trader who wishes to sell, there is a buyer. If you trade through a broker or bank — which even includes exchanging cash for traveling — then the broker or bank acts as the market-maker. Said another way, they trade with you and then trade on a major exchange.
Market-makers affect options in a wholly different manner. Originally, on stock and commodity exchanges, the market-maker for the underlying security would also make a market in calls and puts. The majority of options trades these days, however, are made between a market-maker and the buyer or seller. That is, as an options trader, you are working directly with the market-maker, not a removed counter-party.
Options market-makers try to balance trades by using spreads, by dealing with other market-makers personally, or by staying “delta neutral” (that is, keeping extra stock in their accounts or shorting stock to cancel the consequences of their being naked short the calls and puts they sell to the general market).
The market-maker’s impact on options can be quite significant, often sending options premiums skyrocketing in a matter of minutes. When the price of a stock fluctuates wildly, the market-makers widen the spread on the options so that they cut the risk of a major fund swooping in to capture profits for the day.
The lesson for options traders is that you must realize that every trade you make is with a savvy professional market-maker, one who is going to hedge their bets. You are not trading with another retail investor or with an institutional investor; you are trading with a firm that uses zero-risk strategies to lock in a profit.
It can be challenging to understand how options differ from other investment vehicles, but the big profits that options can bring — with far less capital — can make the little time required to understand the intricacies much easier to bear.
