What Exactly Do Market Makers Do? (& How They Manipulate The Market)

Summary

This script delves into the role of market makers in financial markets, often misunderstood as manipulators due to high-profile incidents like GameStop. Market makers are essential for liquidity, offering to buy and sell securities to ensure smooth trading. However, their profit model, based on bid-ask spreads, and tactics like bear raids, spoofing, and exploiting news cycles, can disadvantage traders. The controversial practice of payment for order flow, where brokers receive payments to execute trades, is also discussed, highlighting the potential conflicts of interest. The video invites viewers to consider whether market makers are beneficial or detrimental to the market.

Takeaways

• 👥 Market makers are institutions or individuals that partner with exchanges to increase liquidity by acting as buyers and sellers for securities.
• 💵 Market makers provide liquidity by guaranteeing to buy or sell stocks at the bid and ask prices, ensuring transactions can occur even if there are no immediate buyers or sellers.
• 📈 The bid price is slightly below the market price, and the ask price is slightly above it, which allows market makers to profit from the spread.
• 🧾 Market makers' offers are usually in units of 100 shares, but larger offers are common for more established stocks.
• 📊 Market makers focus on maintaining a favorable average price of their net position relative to the market price, rather than profiting from every single trade.
• ⚠️ Market makers can manipulate the market using tactics like bear and bull raiding, spoofing the tape, and leveraging the news cycle to move prices in their favor.
• 🚫 Payment for order flow is a controversial practice where market makers pay brokerages to execute trades, potentially leading to wider spreads and higher costs for retail investors.
• 🌍 While payment for order flow is banned in some countries, it remains legal in the US and is a significant revenue source for brokerages.
• 📉 Market manipulation primarily affects short-term traders, making it challenging for them to succeed, while long-term investors are less impacted.
• 🛑 The video suggests avoiding the games of market makers by sticking to long-term investment strategies like dollar-cost averaging.

Q & A

What is the primary role of market makers in financial markets?

Market makers are individuals or institutions that partner with exchanges to increase liquidity by acting as both buyers and sellers for securities traded on the exchange, ensuring that investors can buy and sell shares even when there are no immediate counterparts.

Why do market makers have a bad reputation among some investors?

Market makers have a bad reputation due to the belief that they manipulate the market to their advantage, such as during the Gamestop run when Citadel allegedly pressured Robinhood to halt buying, which is seen as exploiting their power at the expense of retail investors.

What are bid and ask prices, and how do they relate to market makers?

Bid and ask prices are the prices at which market makers are willing to buy (bid) or sell (ask) a stock. These guaranteed offers are just below or above the market price, respectively, and are part of how market makers provide liquidity to the market.

How do market makers make money from their role in the market?

Market makers make money by setting buy (bid) prices slightly lower than the market price and sell (ask) prices slightly higher, thus earning the spread between these two prices. However, they must find counterparties to realize these paper profits.

What is the significance of the bid-ask spread for market makers?

The bid-ask spread is crucial for market makers as it represents the profit margin from their trades. A wider spread makes it easier for them to flip shares for a profit, but it also indicates the level of risk and market volatility they face.

Can you explain the concept of 'payment for order flow' and its implications?

Payment for order flow is a practice where market makers pay brokerages for the opportunity to execute trades. This can lead to conflicts of interest, as brokerages may not always provide the best prices for trades, potentially harming investors by widening the bid-ask spread.

How do market makers use strategies like bear and bull raids to manipulate the market?

Market makers may engage in bear raids by selling large amounts of a stock to drive the price down, triggering stop losses and panic selling. Conversely, in bull raids, they buy shares to create a buying frenzy, often to later sell into the strength and cause the price to drop.

What is spoofing the tape, and how do market makers use it to mislead traders?

Spoofing the tape involves placing large buy or sell orders with no intention to execute, misleading other traders into thinking there is significant interest in a stock. Market makers then cancel these orders, leaving retail investors to buy or sell at manipulated prices.

How does the news cycle affect market makers' strategies, particularly during earnings season?

Market makers can exploit the news cycle, especially during earnings season, by selling into strong earnings reports or buying after the report is released, and vice versa for weak reports. This creates unpredictable market movements that can trap inexperienced traders.

What is the impact of payment for order flow on the relationship between brokerages and market makers?

Payment for order flow can create a conflict of interest, as brokerages may prioritize executing trades with market makers that pay them, rather than seeking the best prices for their clients. This can lead to wider spreads and less favorable trade executions for investors.

How should retail investors approach investing in light of market makers' influence?

Retail investors should consider long-term strategies like dollar-cost averaging to minimize the impact of market makers' manipulations. Avoiding short-term trading and focusing on fundamentals can help protect against the volatility caused by market makers.

Outlines

00:00

🤑 Understanding Market Makers and Their Role

This paragraph introduces market makers, explaining their purpose in the financial markets. Market makers are entities that partner with exchanges to enhance liquidity by acting as both buyers and sellers of securities. They ensure that investors can trade stocks even when there's a lack of buyers or sellers, by offering to buy at the bid price (slightly below market price) and sell at the ask price (slightly above market price). The example of GameStop's bid and ask prices illustrates how market makers operate, providing liquidity and facilitating trade for both retail and institutional investors.

05:02

💸 How Market Makers Profit and Manipulate Markets

This section delves into how market makers generate income and the controversial tactics they sometimes employ. Market makers never trade at the market price; instead, they buy at a lower bid and sell at a higher ask to secure a small profit on each transaction. However, realizing this profit requires finding counterparties for their trades. The paragraph also discusses market manipulation strategies such as bear and bull raids, spoofing the tape, and exploiting the news cycle during earnings season. These tactics can mislead retail investors and create an uneven playing field.

10:02

📉 The Impact of Payment for Order Flow and Market Makers' Influence

The final paragraph addresses the practice of payment for order flow (PFOF), where market makers pay brokerages to execute trades, a practice that has come under scrutiny for potential conflicts of interest. It highlights how PFOF can affect the quality of trade execution for investors, as brokerages may not always seek the best prices when executing trades. The paragraph also reveals the substantial revenues generated by brokerages and market makers from PFOF, suggesting that despite their manipulative tactics, market makers serve a beneficial role for long-term investors by providing liquidity, but caution is advised for short-term traders.

Keywords

💡Market Makers

Market makers are financial institutions or individuals that provide liquidity to the market by acting as both buyers and sellers of securities. They are essential for the smooth functioning of financial markets, ensuring that investors can buy and sell shares even when there are no counterparties available. In the video, market makers are portrayed as having a bad reputation due to their alleged market manipulation, but they are also acknowledged for their intended role in facilitating efficient trading.

💡Liquidity

Liquidity refers to the ability to buy or sell an asset quickly and easily without causing a significant change in its price. In the context of the video, market makers increase liquidity on exchanges by offering to buy and sell securities, thus ensuring that retail and institutional investors can execute their trades without facing delays or price slippage.

💡Bid and Ask Prices

Bid and ask prices are the lowest price that buyers are willing to pay and the highest price that sellers are willing to accept for a security, respectively. The script explains that market makers set these prices, which are typically just below or above the market price, and they guarantee transactions at these prices, thus providing immediate execution for market orders.

💡Spread

The spread is the difference between the bid and ask prices. It represents the cost of trading for investors and is also the profit margin for market makers. The video uses the example of GameStop to illustrate how market makers can have a wider spread on less liquid stocks, which can be exploited for profit but also carries more risk.

💡Manipulation Tactics

Manipulation tactics refer to strategies used by market makers to influence the market in their favor. The video discusses several tactics such as bear raids, bull raids, and spoofing the tape, which involve creating artificial buying or selling pressure to move prices in a desired direction or mislead other traders about market sentiment.

💡Spoofing the Tape

Spoofing the tape is a manipulative practice where market makers place large orders with no intention to execute them, only to cancel them later. This creates a false impression of buying or selling pressure, as illustrated in the script with the example of a market maker placing a large buy order for Apple shares, tricking retail investors into buying before the order is canceled.

💡Payment for Order Flow (PFOF)

Payment for order flow is a practice where brokerages receive payment from market makers for the right to execute client orders. The video explains that this can create a conflict of interest, as market makers may offer less favorable prices to maximize their profits from the payments received, which can be detrimental to the investors' interests.

💡Conflict of Interest

A conflict of interest arises when a party has a duty to act in the best interests of another but also has a competing interest that could potentially influence their judgment. In the video, the conflict of interest is highlighted in the context of payment for order flow, where brokerages may prioritize their own profits over providing the best execution for their clients.

💡Dollar Cost Averaging

Dollar cost averaging is an investment strategy where an investor consistently invests a fixed amount of money at regular intervals, regardless of the asset's price. The video suggests this as a way to avoid the manipulation tactics of market makers, as it reduces the impact of short-term market volatility on investment decisions.

💡Stop Losses

Stop losses are orders set by investors to sell a security when it reaches a certain price, typically to limit potential losses. The video describes how market makers might exploit stop losses by selling large amounts of a stock to trigger a cascade of selling, causing the price to drop and allowing them to cover their short positions at a lower price.

💡Earnings Season

Earnings season refers to the period when publicly traded companies release their quarterly financial results. The video mentions that market makers can use this period to manipulate stock prices, as they may have access to information before the public and can trade based on anticipated market reactions to the earnings reports.

Highlights

Market makers are institutions that partner with exchanges to increase liquidity by acting as both buyers and sellers for securities.

Market makers guarantee to buy or sell stocks at prices just below or above the market price, known as the bid and ask price.

The bid and ask prices are crucial for market makers to maintain liquidity, especially for stocks with low volume.

Market makers make money by offering to buy at a lower price and sell at a higher price than the market, creating a bid-ask spread.

For high volume stocks like Apple, the bid-ask spread is minimal, indicating high liquidity and efficiency.

Market makers must manage their net position to ensure it is favorable relative to the market price to realize gains.

Bear and bull raids are common manipulation tactics used by market makers to move stock prices in a desired direction.

Spoofing the tape involves placing deceptive orders to mislead retail traders about market sentiment.

Market makers can exploit the news cycle, especially during earnings season, to manipulate stock prices.

Payment for order flow is a controversial practice where market makers pay brokerages for the right to execute trades.

Payment for order flow can lead to conflicts of interest, as brokerages may not always provide the best prices for trades.

Many countries have banned payment for order flow due to its negative impact on investors.

Despite their manipulative tactics, market makers play a vital role in facilitating the buying and selling of shares for long-term investors.

Short-term traders are more susceptible to the negative impacts of market maker manipulation.

Dollar-cost averaging is suggested as a strategy to avoid the pitfalls of market maker manipulation.

Market makers have been around for decades and have become adept at market manipulation.

The GameStop run is cited as a notorious example of market maker influence and alleged abuse of power.

Market makers' primary purpose is to ensure smooth and efficient market operations for all investors.

Transcripts

INTRO: If you’re invested in the financial markets,

I’m sure you’ve heard of these big bad institutions called market makers.

We’re often told horror stories that these guys have full control of the market, and

that they manipulate it on a constant basis to suck out as much money as possible from

the average retail investor.

Likely the most famous example of a market maker allegedly abusing their power to influence

a stock was during the Gamestop run when Citadel apparently pressured robinhood to halt the

buying of Gamestop.

This portrayal has given market makers a pretty bad reputation, and to be honest, most market

makers don’t deserve anything better.

However, the concept of market makers wasn’t invented out of bad faith.

In fact, market makers were supposed to help markets run smoothly and efficiently both

for retail investors and institutional investors.

And you could argue that they still accomplish this despite their bad reputation.

But, who exactly are market makers, what exactly do they do, and why do so many investors despise

market makers?

WHAT IS A MARKET MAKER?: Starting off what the basics, let’s take

a look at what exactly a market maker is.

A market maker is simply an individual or institution that partners with an exchange

to increase liquidity on the exchange.

The way they accomplish this is by acting as both buyers and sellers for all the securities

that are traded on the exchange.

Here’s the thing, there’s not always people out there that are willing to buy the stock

your selling or sell you the stock that you want to buy.

This is especially true if you’re trying to sell or buy a massive amount of stock with

low volume.

And this is where market makers step in.

These guys will guarantee to buy or sell the given stock at prices that are just below

or just above the market price.

These guaranteed offers are called the bid and ask price.

For example, let’s take a look at GameStop’s bid and ask prices when the stock was at $136.50.

As you can see, the bid price is $136.12 and the ask price is $136.55.

This means that a market maker is willing to buy Gamestop from you for $136.12 right

now regardless of whether there’s a buyer on the other side.

Similarly, a market maker is willing to sell Gamestop to you for $136.55 regardless of

whether there’s a seller on the other side.

If you put in a market order to buy or sell shares as fast as possible, these are the

prices that they’ll execute at.

If you look closer at these bid and ask prices, you’ll see that there’s the phrase x1

right next to either price.

This indicates how many shares market makers are willing to buy or sell at these prices.

Generally, their offers are measured in units of 100 shares because this is the minimum

that market makers are required to offer at any given time.

Clearly, market makers aren’t willing to offer more than the minimum with Gamestop,

but with more established stocks, their offers are much more substantial.

With Apple, for example, market makers are currently willing to buy 3900 shares at $149.99

and sell 19,700 shares at $150.

As you can see, these offers make it very difficult for the average retail investor

to ever run into a liquidity problem and this makes sense given that that’s the main purpose

of a market maker.

MAKING MONEY: Alright, so market makers aim to make financial

markets more efficient and liquid, but how exactly do they make money?

Well, the answer is obvious, market makers never actually buy or sell at the current

market price.

Their offers to buy are always slightly lower than the market price and their offers to

sell are always slight higher than the market price.

So, they’re automatically in profit the second that they execute you’re trade, but

here’s the catch.

This profit is just on paper.

As a retail investor, you can easily translate paper profits to realized profits by buying

or selling shares to market makers.

But, for market makers to realize their gains, they actually have to find someone who’s

willing take on the otherside of the trade.

For high volume stocks, this is not too difficult and that’s why the difference between the

bid and the ask is just 1 cent for Apple.

But, for a stock like Gamestop, the spread is far larger at 43 cents.

While spreads makes it easier for market makers to flip their shares for a profit, this is

not always possible because stocks aren’t exactly stable.

In fact, they’re rarely stable, and they’re usually going up or going down meaning that

there’s an imbalance between buyers and sellers.

And given that market makers always have to be willing to buy or sell regardless of whether

a security is running up or selling off, market makers inevitably end up with a long or short

position themselves.

But, this is ok because market makers don’t actually try to make a profit on every single

share they buy or sell because that’s simply impossible.

Rather, they focus on the average price of their net position and ensure that it’s

favorable relative to the current market price.

For example, if a market maker were to accumulate a long position, their goal would be to ensure

that their average price is less than the market price.

Conversely, if a market maker were to accumulate a short position, their goal would be to ensure

that their average price is more than the market price.

If at any point, either of these become untrue, we’ll see the bid ask spread naturally widen

as market makers pull back try to get back into a profitable position.

If this is all that market makers did, there wouldn’t be a problem.

In fact, market makers would likely be appreciated for providing liquidity and efficiency to

the financial markets.

However, as you would guess, market makers often use their leverage and influence to

manipulate the markets to make even more money.

MANIPULATION TACTICS: Given that market makers have been around

for decades, they’ve gotten extremely good at manipulating the markets.

They use countless strategies to move the markets in the favor, but we’ll stick to

the most common strategies starting with bear and bull raiding.

This is likely the simplest form of manipulation as market makers are essentially just buying

or selling large amounts of securities to move the price in a specific direction.

But what makes this strategy so powerful is how strategically market makers use it.

For example, lets say a market maker wants Apple stock to fall.

Maybe they have a short position on the company or they want to buy in cheaper.

What they’ll do is wait for Apple stock to reach a price at which there’s a bunch

of stop losses.

And as Apple nears this price, the market maker will go out and dump a bunch of Apple

stock.

This will trigger the stop losses which will cause a domino effect of selling and fear,

and before you know it, the stock will be down 4 or 5% giving the market maker the perfect

opportunity to close their short positions or buy in lower.

This same strategy works on the other side as well.

If a stock is approaching a critical break out level with a bunch of limit buy orders,

the market maker can buy a good amount of shares right underneath this level and cause

a buying frenzy.

This buying frenzy wont last long as the market maker will be dumping their positions into

this strength causing the price to drop back underneath the critical level.

This is usually what’s happening when we see fake outs like these.

Another popular maniupation tactic is spoofing the tape.

This is when market makers put in phony orders into the order book to mislead traders.

For example, let’s say Apple is trading at $101 per share.

A malicious market maker might go ahead and put in a buy order for a million Apple shares

at $100 per share.

Seeing this massive order, retail traders are often led to believe that a massive whale

is buying Apple at $100.

If they’re willing to put in so much money into Apple, surely, they must know something

right?

Well, they don’t, but retail investors don’t know that and they’ll go ahead and put in

their own buy orders at $100.

Right before the stock actually hits $100 though, the market maker will cancel their

order meaning that it’s just the retail investors who are left buying Apple.

In this scenario, the market makers were able to add significant buying pressure to Apple

without spending a single cent themselves.

They can use this same strategy to the upside as well and create a bunch of selling pressure.

Yet another manipulation tactic that market makers use is the news cycle and one of the

most prominent examples of this is earnings season.

Even the most seasoned of traders don’t trade during earnings because they know that

market makers are in full control.

They might sell the stock into a strong earnings report and buy the stock as soon as the report

drops.

Or, they might sell the stock into a weak earnings report and sell it even more the

second the report drops.

This is when you hear things like buy the rumor and sell the news or sell the rumor

and buy the fact.

While these phrases sound smart, you usually have no clue what the market makers have planned

until it’s already too late.

But unfortunately, beginners often buy or sell thinking they know what they’re doing

and usually, they just get obliterated.

One thing to note though is that all these manipulation tactics only hurt you if you’re

trading, and it’s actually why it’s so hard to be a successful trader in the first

place.

If you simply stick to buying and holding though, you don’t have to worry about any

of this.

PAYMENT FOR ORDER FLOW: All of the manipulation tactics that we’ve

discussed so far have been around for ages, but something that’s gained a lot of attention

in recent history is payment for order flow.

Payment for order flow is when market makers pay brokerages for the opportunity to execute

their trades.

This is one of the primary methods that “quote on quote” free brokerages like Robinhood

make their money.

The problem with this strategy is that it’s consequences are not that favorable for the

end user.

For example, brokerages should be trying to get the best prices they can for you to buy

or sell your shares.

Traditionally, brokerages can shop around at a bunch of market makers to get the best

quotes possible.

But when a brokerage locks in with a market maker in return for payment, they’re giving

the market maker substantial pricing power.

The market maker no longer has to offer the best bid and ask prices.

Instead, they can widen the spread to maximize their own profits.

This was actually a major problem in the late 1990s when we first saw zero commission brokers

gain popularity.

At the time, the smallest spreads on these brokerages was $0.125.

This means that if you were selling 100 shares, you were losing out on as much as $12.50.

Clearly, this is a clear conflict of interest and that’s why many countries such the UK,

Australia, and Canada have banned the practice.

However, the practice is still legal within the US and more and more brokerages have turned

to payment for order flow in order to stay competitive with other brokarges.

And these guys generally make tens of millions if not hundreds of millions every quarter

just from selling your order flow.

For example, in Q2 of 2020, TD ameritrde made $324 million, Etrade made $110 million, Schwab

made $66 million and Robinhood made $180 million all from payment for order flow.

And that’s just the money that the brokerages made from the practice.

The only reason that market makers are paying these massive fees is because they have even

more to gain from the practice.

MARKET MAKERS EXPLAINED: As you can see, market makers aren’t there

to screw you over.

They’re actually meant to help you sell and buy shares whenever you want.

And if you’re a long term investor, market makers have likely helped you way more than

they’ve hurt you.

If you’re a short term trader, however, it’s a completely different story.

Market makers make much of their money from manipulating the markets and misleading small

time investors into buying and selling at the worst times possible.

And while we can complain about them all we want, I think the best idea is to just avoid

the situation altogether and simply dollar cost average into whatever you’re looking

to buy, but that’s just what I think.

Do you guys think market makers are a net positive or a net negative?

Comment that down below.

Also, drop a like if you also prefer avoid market makers games altogether.

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