Market makers make money by capturing momentum moves. They also make money capturing the spread, just like NYSE specialists. Market makers also act as commissioned representatives for large financial firms or mutual funds. As reps, market makers become brokers acting on their client’s behalf to buy or sell a security. When market makers act as intermediaries for a big firm, they get paid a commission. The commission is usually the spread between the inside bid and the inside ask. In most cases, small orders from traders like you and me come from a market maker’s own inventory.
The term market maker refers to a securities firm as well as an individual. Examples are Goldman Sachs and Morgan Stanley, firms that are registered to buy and sell specific securities. As market makers, they abide by Nasdaq rules when making a market. Market makers are required by Nasdaq to maintain a two-sided market. This means they are required to post both a bid price and an ask price at the same time.
Unlike specialists and floor brokers, market makers work in offices, using computers and the telephone to make the market. One market maker may handle a single security or 25 at a time. There are approximately 60 market makers trading the 6,000 securities on Nasdaq. Usually, the big-name stocks have 40 or more market makers, while the smaller-name stocks have just a few. Tracking and understanding their methods is vitally important for the day trader.
The Three Main Responsibilities of Market Makers
- Execute transactions for their clients. The most important function is to execute orders for clients at the best possible price. They do this by interacting with other market makers online or by telephone.
- Keep an orderly market. This means they must prevent dramatic fluctuations in the price of a stock that comes under heavy buying or selling pressure. To create this liquidity, market makers must provide a two-sided market within the market bid/ask price. Liquidity happens as market makers fulfill their obligation to make markets throughout the trading day. They must advertise to sell at a certain price whenever they make a bid to buy a stock at a certain price. That’s why it’s called a two-sided market.
- Trade for the firm’s proprietary account. Market makers use inside knowledge, experience, and technology to make profits on a daily basis. They take profits on the stocks they make a market in, but they also take speculative positions on the possibility of future price movements of those stocks—depending on the time of day, the market conditions, and the existing order flow.
Different Types of Market Makers
It is important for day traders to be aware of the different types of market makers and understand the trading patterns they create. Here’s why. Market makers do the lion’s share of trading on the OTC. Big market-making firms, such as Goldman Sachs, Paine Webber, Salomon Brothers, and Merrill Lynch, represent large institutions, such as pension funds and mutual funds. They buy and sell for these clients. They also trade for their own retail customers and their own trading accounts.
The sheer volume of this trading can have a dramatic impact on stock prices. You can watch market makers trading on what’s known as Level II computer screens. Patterns will emerge if you watch them over time. They repeat certain actions throughout the day, giving you insight into their true buy and sell intentions and market direction. Keep in mind that market makers do not always make the right decisions. The market as a whole is always more powerful than any single market maker.
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