A Bandit recently asked me:
“Do you believe market makers and specialists really gun for the orders that are on the books that are only a few hundred shares, or do they only search out bigger size?”
Here’s my response:
My take on market makers and specialists is that they just want volume, all day, as they’re selling on the offer and buying on the bid. A few hundred shares here throughout the day add up to a lot. Stocks will naturally gravitate toward key areas of support and resistance, so if they just get close then it’s not that difficult for market makers to ‘spook’ prices a little further and run some stops.
Suppose there’s resistance just a few cents away, they know buy stops reside beyond that level. Flashing a big bid will have shorts quickly covering based upon the quote (which is real by the way), and buyers step in front of it in hopes of catching a run. They can then flip that large order to the ask and it spooks everyone to sell, taking the stock right back down to where it was.
You can see how doing that throughout the day adds to the back-and-forth range-bound type of price action which churns the accounts of retail traders and leaves the stock not necessarily making any big headway.
Also, do not discount the presence of programs doing this exact same thing. If supercomputers can automate the process via algo’s, all the better for the smart money to spook the retail traders out of positions on a regular basis. Head-fake moves which last only long enough to inflict enough pain to prompt an exit is all it takes, so it need not be a lasting move to catch the small trader off guard and separate him from a dime here or a quarter there.
One last thing…
On a trend day when market makers are shorting into strength (selling on the offer during an uptrend ), if they didn’t have a lot of inventory to dump, then they’re getting shorter the higher we go. They will hedge via futures (ES or NQ) or through options. Those derivatives have a huge impact on how the market moves, yet few traders really recognize that.
So when people watch call buying activity or put buying activity in the options, they think they know that someone big is betting on a rise or fall in the shares, but the fact is nobody knows if it’s that simple or if it’s part of a more complicated hedge for a market-neutral position.
It gets cloudy, but there’s my take on market makers and specialists. What’s your opinion?
Hi Jeff,
Good article.
You are missing one part though, how the high speed access lines lets high frequency traders even bypass using real bids.
I have read that the biggest issue now is with high speed lines, the bids do not even have to be real.
The exchanges are the real culprits. Selling the HFTs high speed access lines that allow them to place bids and cancel those bids so close to simultaneously that they cannot be hit.
The result is the same as if they were real – many brokers execute stop orders based on bid and ask, not last. As these phony bids march downward, the stops execute.
It only gets worse. Remember these bids have been cancelled before they can be hit. They only feed in the real bid that is not cancelled way lower in price. A stop is a market order. How many times have you had a stop execute 10 or 20 cents lower than your stop setting?
Once they own the stock, they now reverse the direction doing false bids to make it look like it has taken off. Once they dump their holdings at a high price, they can then run it up high enough to people to start taking profits, and then another sad surprise, it starts shooting down and your market sell order executes 10 to 20 cents lower since the high bids out there were not real.
The market would not be worth playing except for when there is that wonderful combination of momentum and volume. Typically after the markets have been open an hour or so, there are enough large investors – as you call them, whales – that the HFTs cannot force the prices as easily. The number of “head fakes” goes down.
That first hour of trading can give you whiplash!
On the positive side, institutional investors not using HFT are starting to get fed up. They also suffer from this theft. Let’s hope they demand an end of the exchanges renting the equivalent of ATMs, these high speed lines that empty money out of the honest trader’s pocket.
Thanks for the comments here John, it definitely gets real intricate when discussing all this stuff.
I think one issue here is the use by us both of the word ‘real.’ When I say ‘real’ what I mean is that if you were to execute against a bid you see, the buyer has to honor it. Same way on the offer side. When you say ‘real’ what I think you mean is that they never intend to execute at that price since they’re only flashing an order for a brief moment (millisecond!). They have deep enough pockets to honor the order, should it get hit, but as you noted they likely don’t intend to execute there. All the machines may at some point cannibalize each other to a certain extent, but what would be ideal is this solution the Nasdaq is considering:
https://www.bloomberg.com/news/2011-10-28/nasdaq-omx-plans-minimum-life-orders-on-psx-stock-exchange.html
Got that link from a fellow bandit (thanks Joel!), and it’s a simple but effective way to combat some of this. It won’t make things easy, but would likely change how the HFT’s are operating, at least to an extent.