What Is A Market Maker and Why Do We Need Them? (MM Examples Included)

by OTC Financial | Last Updated: 12 months ago
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What is a Market Maker? A market maker provides liquidity in the trading process.

They are responsible for providing bids and offers, which helps create an active marketplace of buyers and sellers.

Creating bids and offers for traders on both sides of the trade helps create an active marketplace where supply meets demand by allowing transactions to be executed.

This article will discuss what a market maker does, how they make money, provide examples, and explain why you need them.

What Does It Mean To Be A Market Maker

You are a market maker if you make it your business to take risks in the marketplace.

You use your knowledge and ability to turn some of that risk into a reward for yourself, for other people, or both.

Market makers are traders who always have orders waiting to buy and sell, even if the price changes dramatically.

A market maker is an organization/someone who buys and sells securities for their own organization’s account at prices that depend on supply and demand.

Market makers provide liquidity in the marketplace by ensuring an interested buyer or seller for every security they trade.

Their active role helps keep prices stable and facilitates transactions.

Market makers also provide an essential service to investors by providing them with a way to exit a position without waiting for another (retail) buyer or seller.

How Do Market Makers Set Prices

Market makers are responsible for setting prices in the stock market.

They consider several factors that influence how and what they set prices at when they do.

These six factors have been shown to play a significant role in the pricing process:

  1. Supply & Demand
  2. Speculation
  3. Past Price Performance
  4. Economic Conditions
  5. Social Media Sentiment Data
  6. Company News Events

How Do Market Makers Make Money

Market makers can do this by taking into account the risk-reward equation.

The market maker will set a price at an equilibrium point, where they can still make some money on their position while minimizing their risk exposure and maximizing trading volume.

Bid-Ask Spread is a common term for the difference in price between what buyers and sellers offer.

The bid volume is how many people want to buy, and the ask volume is how many people want to sell.

Market makers need to consider these two numbers when setting prices for stocks or other traded assets because they can affect supply and demand.

The difference between the Bid-Ask is called the Spread, and one-way market makers make money typically between buying lower near the Bid price and selling their positions higher on the Ask price.

What Is A Stop Order?

An essential stop order tells the securities exchange to automatically sell a holding (at market price) once it drops below a preset value.

This type of order is also called a stop loss because you enter it at the limit price you want to sell and let the market dictate whether your stock trades down that far.

You can’t see these orders anywhere publicly.

This means when a decrease in share price triggers your limit order, they become live orders on exchanges to sell your position at the current market price.

Stop-losses protect against extreme losses while investing; entire stop-loss orders are sent to the exchanges, but their visibility is hidden from the market makers.

Can Market Makers See Stop-Loss Orders

Market Makers have access to all the same information that you do when they trade, but not your stop-loss orders.

Stop-loss orders are not shown in the Level2 data order book, and therefore both market makers and retail traders are NOT able to see stop-loss orders for securities.

Stop-loss orders such as trailing stop orders stay in place directly visible only with your broker, rather than getting canceled and replaced in the actual marketplace exchange.

If the market makers move the stock price direction towards your stop-loss and your order is executed, this is the only way the market makers will have visibility of your mostly hidden stop-loss order.

Market Maker Manipulation

How Market Makers Manipulate Stock Prices? There are many ways in which market makers can manipulate the prices of stocks.

The most common methods include:

  • Manipulating Supply and Demand

When a stock is trading low, it’s possible to buy up all available shares on the open market from other investors at a low price.

Then you can artificially raise the stock price by selling off your shares in bulk at a higher price.

  • Manipulating Price Limits

When prices are too high, a market maker can buy orders at lower than expected costs to create the illusion of low demand or selling activity.

This will usually cause other investors to panic and sell off their stocks as they believe there is no point in holding on with such decreased values.

  • Widen Bid-Ask Spreads

Markets are subject to the laws of supply and demand, but these forces explain not all market behavior.

Market Makers can hypothetically widen bid-ask spreads to signal that they need shares or if he’s temporarily bringing down prices; other Market Makers will follow suit because it signals an opportunity for them as well.

The challenging part becomes knowing when there’s manipulation behind the scenes. When markets behave rationally according to Supply & Demand – retail traders have difficulty reading between the lines here.

  • Thinly Traded and Low Float

The fewer shares that trade hands, the easier it is for a big wave of buying to move the price.

When very few shares are sold, any significant purchase may push prices upwards considerably.

As the supply of a stock dwindles, it becomes easier for one large purchase to cause significant movements in price.

When few shares are being sold, any significant buy could push prices up significantly.

Market makers use signals to communicate, so they know how other institutions are trying to make the stock go. Different market maker signals have different meanings.

They appear as a specific share amount traded which shows up on the Level2 order book Time and Sales for others to see.

These are just a few market makers used to manipulate stock prices.

Market makers work hard to find new and creative strategies as they constantly need to adapt their tactics to stay ahead of investors and competitors.

Ultimately, the challenging part for retail traders is knowing when deliberate manipulation is going on or if markets are behaving rationally according to supply and demand.

Market Makers Creating Liquidity (Stop Hunt/Stop Fishing/Bear Raiding)

In periods of low market volatility, market makers may attempt to Stop Hunt to trigger stop losses to create trading volatility.

When these types of trades are executed, trading volume increases and brings more participants into the security than would exist otherwise.

So even though an individual may not want their stop order filled immediately at the market price, there could be instances where executing those orders is beneficial for both buyers and sellers because it generates greater market liquidity.

Limit Order vs Stop-Limit Order

What is a limit order? A limit order is a type of order used in stock trading that allows you to set a price you are willing to buy or sell your shares.

A limit order is always triggered after the stock reaches a specific price set by the investor – if and only if it is profitable for them.

What is a stop-limit order? Stop-loss orders, for example, are considered to be limit orders since they are triggered once your security reaches or exceeds a particular price; however, you’re not at all guaranteed to get filled on that order within an affordable or favorable time frame.

Final Thoughts

What does it mean to be a market maker?

Market makers are responsible for creating bids and offers, which helps create an active marketplace of buyers and sellers.

Creating bids and offers for traders on both sides of the trade helps create an active marketplace where supply meets demand by allowing transactions to be executed.

Market maker manipulation is when a market maker creates artificial trading to make money from going up or down prices.

This type of behavior can cause a lot of turmoil in the markets because it impacts peoples’ savings and investments.

Understanding how to view Market Maker activity on Level2, check the Time and Sales Order Book, and know a little about how market makers operate before making trades will help give you an advantage when learning to trade penny stocks.

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