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.