Newbie Question: What is Market Maker's Role in Bid/ask?

[mastertonster 10]

Hi, stock trading is pretty new to me. And I'm here to hopefully learn from you experienced traders about all things related to stock markets.

I have some basic understanding of the market but I have a long way to go. My questions may sound stupid but here they are..

From my understanding, at any given moment, bid is the highest purchasing price some buyer had entered his order for. And the ask price is the lowest a seller had enter his sell order. I also understand that market makers are suppose to take the opposite side of the trade whenever someone enters the order. But it sound kind of weird. If I were to buy at Ask, who am I exactly getting the shares from? the market maker? or some counter party- a traders like myself who has entered a sell order priced at the Ask..

Another question is, I've heard all the stock transactions have all become electronic in recent decade. Do market makers still exist? Where are they physically? Were they the one's standing on the exchange floors hollering back and forth?

Can someone please explain? Thank you.

[Patuca 13]

Were they the one's standing on the exchange floors hollering back and forth?

Can someone please explain? Thank you.

LOL most everyone is hollering for the good ole days especially the floor boys now that the flash boys have appeared in all their cunning and might.

 

If it is any consolation charts still look the same...generally i.e. Trends...pull backs...ranges..breakouts..more trends..strong (spikes and breakouts)...channels (weaker trends), sideways (ranges), more trends strong and weak...PB..then breakouts or ranges...over and over and over again ad nauseam. At least the hollering and screaming added some diversion to such a boring job. Now days you have scream at the computer or jump on top of the desk and shake the daylights out of it. 70% or more of trading is via cold..unfeeling..drab...computers that use algos and htfs powered by the computers which in turn are obeying calculating humans. It is the invasion of the machines. In the old days one could mess with the MM's and specialist. Now one is pitted against the machines. They can still be beaten though because algos are devised by humans and until human nature changes there will always be trends...breakouts..channels...ranges..flags..pennants..triangles...etc more ad nauseam. It simply is not as fun beating a machine as beating another human in the markets. Nevertheless, the money is there and it can be taken.

[BlueHorseshoe 10]

Hi, stock trading is pretty new to me. And I'm here to hopefully learn from you experienced traders about all things related to stock markets.

I have some basic understanding of the market but I have a long way to go. My questions may sound stupid but here they are..

From my understanding, at any given moment, bid is the highest purchasing price some buyer had entered his order for. And the ask price is the lowest a seller had enter his sell order. I also understand that market makers are suppose to take the opposite side of the trade whenever someone enters the order. But it sound kind of weird. If I were to buy at Ask, who am I exactly getting the shares from? the market maker? or some counter party- a traders like myself who has entered a sell order priced at the Ask..

Another question is, I've heard all the stock transactions have all become electronic in recent decade. Do market makers still exist? Where are they physically? Were they the one's standing on the exchange floors hollering back and forth?

Can someone please explain? Thank you.

 

Hi Mastertonster,

 

You have the basic idea, so answering your question is easy enough . . .

• Orders can be divided into two types: passive and active.
   
  
• Passive orders are limit orders. They're placed on the order book at the exchange, and will sit their until an Active order fills them. Think of Passive traders as "patient" traders.
   
  
• Active traders are "impatient" - they want their order filled now! They use Market orders. They just agree to buy at the lowest price that a Passive trader is willing to sell at (the Ask). Orders that are 'stops' are Active: until price reaches the stop level they are stored on your broker's servers, and then they become a Market order.
   
  
• Here's an example . . .
   
  
• The highest bid is 98. The lowest ask is 101. The gap between them is known as the Spread.
   
  
• If you want your Buy order filled right now, who do you trade with? The best available counterparty is the person who is willing to sell at 101. So you must cross the spread and buy from them at 101, paying 3 ticks more.
   
  
• If you try to Buy 50 shares and the Passive sellers at 101 are only offering to sell 20, then you will become a counterparty to the Passive sellers at 102, and so on . . . If the number of Passive sellers is low then your order will be filled at increasingly higher prices - this is known as "slippage".
   
  
• If you're willing to be patient, then you can simply join the queue of people willing to buy at 98 by placing a limit order at that price. What you're hoping is that some impatient seller will cross the spread and start selling to the Passive limit order buyers at 98.
   
  
• However, this may never happen, or there might be so many people ahead of you in the queue that the Active buyers are exhausted before you find a counterparty.
   
  
• If you're Passive you know the exact price at which your trade will execute, but you don't know whether it will happen or not.
   
  
• If you're Active then you can be certain that your trade will execute, but you cannot be sure at what price.
  

 

BlueHorseshoe

[BlueHorseshoe 10]

Moving on to Market Making . . .

 

• The market maker attempts to earn the spread on each trade. In doing so, they act as counterparty to both Active Buyers and Active Sellers, and therefore facilitate trade, literally "making" the market.
   
  
• As a market maker you will typically act passively, having both buy and sell orders in the market at any one time.
   
  
• Ideally what you want is for an Active Seller to match your bid at 98 (making you long), and then an Active Buyer to match your ask at 101 (making you flat). This round trip just earned you the spread - 101-98=3 ticks profit.
   
  
• Market making has always been a lot more complicated. You might have orders in the market in hundreds of stocks at any one time. Your risk becomes more complicated as soon as you hold a position (you want to complete a round trip as quickly as possible). So you might begin to skew, or "lean" your book, having slightly more sell orders than buy orders, for example.
   
  
• Also, having access to the information about the willingness of informed Active market participants, you might begin to develop a slightly longer term directional view of the market, causing you to lean your book further to take advantage of this.
   
  
• Much of what HFTs do is just a super high speed version of this, in which computers identify mathematically optimal scenarios based on available information, and can adjust your book in milliseconds as this information changes. Being computers, they can also do this across thousands of markets, internationally, at once.
   
  
• Market makers in stocks were typically guys with computers (not HFT) on the floors of stock exchanges. Market makers in options and futures were typically the guys shouting in the pits of futures exchanges. They both did a similar thing. And both have now largely been replaced by HFT.
  

 

Hope that all makes sense - please ask any questions!

 

BlueHorseshoe

[mastertonster 10]

BlueHorseshoe, thanks for your thorough explanation. Those are definitely helpful to my learning of the market. If you don't mind I follow up with a couple more questions.. I wanna see if I understand correctly. So, in any given moment, with any stock, any bid/ask spread. The prices at Bid or Ask are "passive orders" entered by Market Makers? what about people like myself? Are my buy or sell orders(say lower than bid or higher than ask) buried within a long queue of orders? Sorry. I'm a little confused. :doh:

I understand market makers' job is to provide liquidity in the market, but then why are certain stock have so illiquid and have huge bid/ask spread? Does this mean they're not involved in the particular stock? Thank you.

[BlueHorseshoe 10]

BlueHorseshoe, thanks for your thorough explanation. Those are definitely helpful to my learning of the market. If you don't mind I follow up with a couple more questions.. I wanna see if I understand correctly. So, in any given moment, with any stock, any bid/ask spread. The prices at Bid or Ask are "passive orders" entered by Market Makers? what about people like myself? Are my buy or sell orders(say lower than bid or higher than ask) buried within a long queue of orders? Sorry. I'm a little confused. :doh:

I understand market makers' job is to provide liquidity in the market, but then why are certain stock have so illiquid and have huge bid/ask spread? Does this mean they're not involved in the particular stock? Thank you.

 

Hello,

 

Sorry for the delayed response!

 

The Bid & Ask are always "passive" orders, but they're not necessarily Market Maker's orders. You too can post a limit order and be passive - just wait to see if it gets filled.

 

Where your orders sit in the queue will depend on the contract/security and the exchange it trades on.

 

Stocks on the NYSE will, I think, still have Market Makers (known on that exchange as 'specialists'). They probably get priority on fills (ie their passive limit order is moved to the front of the queue regardless of when they join), I can't remember for certain though.

 

An instrument like the e-mini S&P futures contract, which trades on the CME, is operates on a FIFO basis ('first in, first out'), which means no matter who you are you join the back of the queue at the time you join. The only way to become front of the queue is if the orders ahead of yours are either cancelled or filled.

 

I am not certain, but I think I recall that there are still (electronic, and probably HFT) a form of Market Maker for these futures products as well, called "designated liquidity providers". They get perks (rebates, waived exchange fees etc), but not priority in the queue.

 

With regard to wide spreads . . . the spread is only as wide as you and other traders make it. If you post inside the spread you will narrow it. In very liquid instruments the spread is kept at the minimum price increment of one tick or one cent at all but the most volatile of times. I can count on one hand the number of times I've seen a two tick spread in the ES last more than the blink of an eye.

 

Finally, all various forms of Market Maker have specific mandates to work with. A common requirement is that they maintain both a bid and ask at all times (needn't be the best bid and ask though). Another is simply that account for a certain volume of trading per day. Market makers and market-making algorithms from electronic trading firms may still be present when the Bid and Ask are wide - they just don't see any need to help narrow it by posting inside it. Remember, they make their money from the spread, so they want it wide.

 

If you have any more questions then let me know and I will do my best to answer.

 

Kind regards,

 

BlueHorseshoe

[Patuca 13]

A tactic that some traders used alot in the past was to scan several stocks for an abnormal wide spread in that particular stock and place an inside bid to buy ..limit order..and then when filled place and inside offer to sell thus attemping to take a slice out of the wide spread. Or vice versa on the short side. They would look at the size of the present inside bid and offer to determine where the pressure was..i.e. long or short side.... and then implement the technique accordingly. This could be done over and and over until the MM or specialist ...if NYSE.... determined what one was doing and narrowed the spread thus removing the opportunity.

Edited April 13, 2014 by Patuca

[BlueHorseshoe 10]

A tactic that some traders used alot in the past was to scan several stocks for an abnormal wide spread in that particular stock and place an inside bid to buy ..limit order..and then when filled place and inside offer to sell thus attemping to take a slice out of the wide spread. Or vice versa on the short side. They would look at the size of the present inside bid and offer to determine where the pressure was..i.e. long or short side.... and then implement the technique accordingly. This could be done over and and over until the MM or specialist ...if NYSE.... determined what one was doing and narrowed the spread thus removing the opportunity.

 

I guess you could even do this simultaneously in numerous stocks to try and remain delta neutral to any sudden sector or index shift?

 

For the OP: if what Patuca is discussing is of interest you might like to do a bit of research into the 'SOES Bandits'. I'd also recommend Scott Paterson's book 'Dark Pools'.

 

BlueHorseshoe