Is the market maker really watching your every move? Knowing where your stop and limit order are? In this article the author tries to separate fact from fiction.
I just finished a training session on the internet and I answered a question that I have answered 100 times before or more. It got me a bit worked up because there is far too much mythology out there about the market and how it works and who does what to whom. I am going to attack one of the straw men of trading myths.
It is widely thought among beginners and sadly many veterans alike that there is a boogey man in the closet; a little man behind the green curtain that pulls strings and levers and takes my trade away from me.
This misperception was generated in the early days of the NASDAQ electronic trading platform. In the early days when electronic (versus open outcry – face to face) trading was just getting started there were instances of market makers adjusting order flows to stretch spreads.
They would delay market orders so they filled at higher or lower prices when the prices were moving fast. There were also some instances of prices being manipulated to hit pockets of stop loss orders that were visible on the screens. A number of lawsuits and firings and license revocations stopped that very quickly, but myths prevail and it seems that people need to have demons to explain calamities and excuse their shortcomings. The calamity is that trading skills often do not match the market conditions. When that happens please have the sense not to blame the mean nasty conniving market maker.
Fact: The market maker does not know or care much about you, at least not in a negative way. A market maker wants you to be there because with out you they are out of business. But you are not a target to abuse. You are a number, you are a single trade in a day of hundreds it not thousands of trades and the five to thirty cents your trade makes will not be more than a drop in a bucket to them. They want your trade and will compete with other market makers to get your business. When you place an order in the spread the market makers may debate whether to meet your request, and if it is reasonable some hungry market maker will take it even if the others don’t want to. You represent their livelihood but you are not FOOD!
Fact: Except in a few extraordinary cases, prices have to move incrementally. That means the idea of market makers jumping up or down to grab your stop bogus. It is illegal and would get picked up by the regulatory process. The exceptions are as follows; a gap in over night trading can give the market maker a right to gap prices. A Fast Market (wild irregular trading) condition gives some leeway for market makers to catch up. Market makers can in certain cases also move prices with out corresponding price action. If volatility changes in the market and there are no active orders on the ‘book’ they can adjust option prices. In that case they can adjust prices to actual changing conditions. Otherwise they can not just move prices around to look for your stop. They can push a price up or down by manipulating the bid and ask but generally there has to be stock movement and or volatility movement before prices can be adjusted.
Fact: Your stop is not visible to the market maker. Even if it is an actual order, if it is away from the price it is invisible to them. Until the price action approaches your stop (close to the money) they can not see it. Once it is close to the money it is visible but the above rules apply.
Fact: A market maker can not skip your order either. They are required to trade 100 shares or one contract before moving a price so if you place an order of 100 shares or 10 contracts and you don’t get filled they did not skip you and if you had only one or two contracts fill it would be perfectly legal. If your 10 contract order was an ‘All or Nothing’ and you got nothing, they they were not obligated to fill it for you. However if no orders had yet been traded at that price and it was not an ‘All or Nothing’, they would be obligated to take part of your order because they can not back away from a trade. At least 100 shares or one contract must be traded before prices can be moved if there are legitimate orders in line. So, if there is a Bid and Ask showing and you place an order here is what can happen…
1. You get filled (probably there is some volume and you are part of it).
2. You get partial fill and the price moves (they are reading volume and momentum and decide to move the price; orders can be partially filled and market orders can be spilt up and filled at the next price).
3. You get no fills and the price goes up (one hundred shares had already been traded before your order showed up and your order prompted them to raise the price).
4. No trades go through but the price goes up and you do not get filled (you offered in the spread and they have no obligation to bargain- they can move it and hope you come after it).
Games:
There is definitely an element of gamesmanship that is legal. Generally the market maker will have more experience and will be better at it than you. That is not illegal but definitely painful to the rookie who may feel cheated, but if a rookie takes on the pros and loses it is not because of cheating.
Fishing:
Option trading is where most fishing goes on. Slow volume means orders come through one at a time and so there can be an electronic face off between you and the market maker. They are not trying to cheat or hurt you and generally it is the trader that pushed the button that starts the game. As stated earlier, if you hit the Bid or Ask, your order will almost always go through but, if you offer in the spread and there is light volume, it can be like poking a wasp’s nest with a stick. It’s like offering some one ten dollars for their twenty dollar chair. You started it. So you send in the order and it is not filled and the price goes up. Whoa, you think “Cool. It’s moving my way, I’ll try again but I still want to get a discount”, so you offer in the spread again. Same thing happens so you quickly raise your price to the Ask and buy before it gets away from you. Now the price settles back down and you are frustrated. If you were to check out the volume you would find that you were the only order and you were played. If you had offered at the Ask the first time it would have probably been filled but, your offer allowed them to move the bait which you hungrily chased. At the other end, a market maker smiles, nods their head and is thankful you came to play at their house today.
Taking out stops:
This is classic misrepresentation. First of all, as stated above, price movement is controlled. Secondly, they are invisible especially if you use contingent stops which technically don’t even exist. Thirdly if you are doing card tricks with three year olds, you don’t have to hide the cards really well. Look, market makers learn from experience that people are basically lazy and creatures of habit. If a stock dips to seventy dollars and rises a bit, it may indicate that buy stops kicked in.
If volume increases it may indicate stops were present as stops do tend to be set at whole numbers. Well that kind of sets a precedent for the next trip to support. If you set your stop at seventy and get hit only to see it bounce you may feel violated and cheated, but remember three year olds are easily impressed and offended. When a pheasant hunter goes into a field they look for stands of tall grass. They send the hunting dog over to rustle the grass and if birds fly up, were the hunters cheating? No, they are just good hunters. Folks, this is their business and it is a competition but not a war. Businesses may fight each other but not their customers. Now salesmanship will dictate that they try to get the customer to pay the best price but they are not out to get you! If you make it easy for them by your lack of skill it is not their fault and they are not the bad guys.
I train my students to use contingency stops so that they are completely invisible to the market but not because I am afraid of market makers. I want the student to set up If –Then scenarios that keep them neutral in their trading. I also show them where the traps and land mines may be and where stops make the most sense. It is simply learning to play the game and a big part of that is learning the competition. The retailer is not your enemy, they want your business and they do provide a service but you must learn to not overpay or fall for that flashy lure because the pros are not going to dumb down the game for you.
There are effectively floor cops for the exchanges and very strict rules. The Floor Governors committee has over 20 checks and balances to monitor and regulate ALL trades. No one can operate in a vacuum or under the wire. Time stamps record every action and if you suspect foul play you have the right to request a time stamp and proof that your order was handled to the letter of the law. If there is a mistake it is corrected in your favor. If foul play was uncovered it could cost the market maker their license. By the way in 1999 a seat on the NYSE sold for 2.6 million dollars. Currently a NYSE seat goes for 1.1 million dollars and the Chicago Board Options Exchange (CBOE) seats go for $590,000. Try to imagine a market maker risking that investment over a fifteen cent spread. FOLKS, listen to me… it does not happen. Manipulation happens and games are played but not like the myths and stories suggest.
So… please let go of the blame, the rhetoric and epitaphs that so conveniently hide our own deficiencies as traders. Step up and own your skill level and do something about it.
Ryan Litchfield
http://www.ryanlitchfield.com
I just finished a training session on the internet and I answered a question that I have answered 100 times before or more. It got me a bit worked up because there is far too much mythology out there about the market and how it works and who does what to whom. I am going to attack one of the straw men of trading myths.
It is widely thought among beginners and sadly many veterans alike that there is a boogey man in the closet; a little man behind the green curtain that pulls strings and levers and takes my trade away from me.
This misperception was generated in the early days of the NASDAQ electronic trading platform. In the early days when electronic (versus open outcry – face to face) trading was just getting started there were instances of market makers adjusting order flows to stretch spreads.
They would delay market orders so they filled at higher or lower prices when the prices were moving fast. There were also some instances of prices being manipulated to hit pockets of stop loss orders that were visible on the screens. A number of lawsuits and firings and license revocations stopped that very quickly, but myths prevail and it seems that people need to have demons to explain calamities and excuse their shortcomings. The calamity is that trading skills often do not match the market conditions. When that happens please have the sense not to blame the mean nasty conniving market maker.
Fact: The market maker does not know or care much about you, at least not in a negative way. A market maker wants you to be there because with out you they are out of business. But you are not a target to abuse. You are a number, you are a single trade in a day of hundreds it not thousands of trades and the five to thirty cents your trade makes will not be more than a drop in a bucket to them. They want your trade and will compete with other market makers to get your business. When you place an order in the spread the market makers may debate whether to meet your request, and if it is reasonable some hungry market maker will take it even if the others don’t want to. You represent their livelihood but you are not FOOD!
Fact: Except in a few extraordinary cases, prices have to move incrementally. That means the idea of market makers jumping up or down to grab your stop bogus. It is illegal and would get picked up by the regulatory process. The exceptions are as follows; a gap in over night trading can give the market maker a right to gap prices. A Fast Market (wild irregular trading) condition gives some leeway for market makers to catch up. Market makers can in certain cases also move prices with out corresponding price action. If volatility changes in the market and there are no active orders on the ‘book’ they can adjust option prices. In that case they can adjust prices to actual changing conditions. Otherwise they can not just move prices around to look for your stop. They can push a price up or down by manipulating the bid and ask but generally there has to be stock movement and or volatility movement before prices can be adjusted.
Fact: Your stop is not visible to the market maker. Even if it is an actual order, if it is away from the price it is invisible to them. Until the price action approaches your stop (close to the money) they can not see it. Once it is close to the money it is visible but the above rules apply.
Fact: A market maker can not skip your order either. They are required to trade 100 shares or one contract before moving a price so if you place an order of 100 shares or 10 contracts and you don’t get filled they did not skip you and if you had only one or two contracts fill it would be perfectly legal. If your 10 contract order was an ‘All or Nothing’ and you got nothing, they they were not obligated to fill it for you. However if no orders had yet been traded at that price and it was not an ‘All or Nothing’, they would be obligated to take part of your order because they can not back away from a trade. At least 100 shares or one contract must be traded before prices can be moved if there are legitimate orders in line. So, if there is a Bid and Ask showing and you place an order here is what can happen…
1. You get filled (probably there is some volume and you are part of it).
2. You get partial fill and the price moves (they are reading volume and momentum and decide to move the price; orders can be partially filled and market orders can be spilt up and filled at the next price).
3. You get no fills and the price goes up (one hundred shares had already been traded before your order showed up and your order prompted them to raise the price).
4. No trades go through but the price goes up and you do not get filled (you offered in the spread and they have no obligation to bargain- they can move it and hope you come after it).
Games:
There is definitely an element of gamesmanship that is legal. Generally the market maker will have more experience and will be better at it than you. That is not illegal but definitely painful to the rookie who may feel cheated, but if a rookie takes on the pros and loses it is not because of cheating.
Fishing:
Option trading is where most fishing goes on. Slow volume means orders come through one at a time and so there can be an electronic face off between you and the market maker. They are not trying to cheat or hurt you and generally it is the trader that pushed the button that starts the game. As stated earlier, if you hit the Bid or Ask, your order will almost always go through but, if you offer in the spread and there is light volume, it can be like poking a wasp’s nest with a stick. It’s like offering some one ten dollars for their twenty dollar chair. You started it. So you send in the order and it is not filled and the price goes up. Whoa, you think “Cool. It’s moving my way, I’ll try again but I still want to get a discount”, so you offer in the spread again. Same thing happens so you quickly raise your price to the Ask and buy before it gets away from you. Now the price settles back down and you are frustrated. If you were to check out the volume you would find that you were the only order and you were played. If you had offered at the Ask the first time it would have probably been filled but, your offer allowed them to move the bait which you hungrily chased. At the other end, a market maker smiles, nods their head and is thankful you came to play at their house today.
Taking out stops:
This is classic misrepresentation. First of all, as stated above, price movement is controlled. Secondly, they are invisible especially if you use contingent stops which technically don’t even exist. Thirdly if you are doing card tricks with three year olds, you don’t have to hide the cards really well. Look, market makers learn from experience that people are basically lazy and creatures of habit. If a stock dips to seventy dollars and rises a bit, it may indicate that buy stops kicked in.
If volume increases it may indicate stops were present as stops do tend to be set at whole numbers. Well that kind of sets a precedent for the next trip to support. If you set your stop at seventy and get hit only to see it bounce you may feel violated and cheated, but remember three year olds are easily impressed and offended. When a pheasant hunter goes into a field they look for stands of tall grass. They send the hunting dog over to rustle the grass and if birds fly up, were the hunters cheating? No, they are just good hunters. Folks, this is their business and it is a competition but not a war. Businesses may fight each other but not their customers. Now salesmanship will dictate that they try to get the customer to pay the best price but they are not out to get you! If you make it easy for them by your lack of skill it is not their fault and they are not the bad guys.
I train my students to use contingency stops so that they are completely invisible to the market but not because I am afraid of market makers. I want the student to set up If –Then scenarios that keep them neutral in their trading. I also show them where the traps and land mines may be and where stops make the most sense. It is simply learning to play the game and a big part of that is learning the competition. The retailer is not your enemy, they want your business and they do provide a service but you must learn to not overpay or fall for that flashy lure because the pros are not going to dumb down the game for you.
There are effectively floor cops for the exchanges and very strict rules. The Floor Governors committee has over 20 checks and balances to monitor and regulate ALL trades. No one can operate in a vacuum or under the wire. Time stamps record every action and if you suspect foul play you have the right to request a time stamp and proof that your order was handled to the letter of the law. If there is a mistake it is corrected in your favor. If foul play was uncovered it could cost the market maker their license. By the way in 1999 a seat on the NYSE sold for 2.6 million dollars. Currently a NYSE seat goes for 1.1 million dollars and the Chicago Board Options Exchange (CBOE) seats go for $590,000. Try to imagine a market maker risking that investment over a fifteen cent spread. FOLKS, listen to me… it does not happen. Manipulation happens and games are played but not like the myths and stories suggest.
So… please let go of the blame, the rhetoric and epitaphs that so conveniently hide our own deficiencies as traders. Step up and own your skill level and do something about it.
Ryan Litchfield
http://www.ryanlitchfield.com