Market Makers – The Motley Fool UK

People are often confused about how prices are actually set, so let’s look at one or two issues in a little more detail, based on genuine complaints that occasionally arise.

Imagine a situation in which a company announces good news – whether it’s excellent results, updated forecasts, information about a big contract, etc. – and that many people want to get in quickly, before the price goes up. As soon as the doors of the market are opened, legions of investors flock in and start asking their brokers for quotes. But the price has already gone up and people are complaining that the market makers cheated by marking up the price before any trades took place.

Misunderstandings

These complaints are based on a few related misunderstandings. First, when the market opens, a stock doesn’t need to start at the same price it closed the day before, so there’s nothing sneaky about raising the price before the open. Also, people often don’t understand that the prices quoted by market makers at any given time reflect the balance between supply and demand at that time, and they need to price in such a way that they can both buy and sell the shares.

If a market maker knew that, say, a company had reported earnings 10% higher than expected and was opening its books at the previous evening’s closing prices, he simply wouldn’t find anyone willing to sell shares (because potential sellers will have heard the good news as well), so he couldn’t offer us any to buy – market makers tend to keep a relatively small float of shares, which would run out almost immediately.

So if it appears that a market maker is trying to trick you into instantly increasing their prices by 10% when you want to buy some, that’s because they’ll also have to pay 10% more to get anyone to sell to them. .

Can’t buy enough?

A related complaint, when a stock’s price rises, is that it’s impossible to buy a decent amount of stock, and we hear complaints that market makers are holding stocks, or hoarding them, waiting for ‘they go up even more before they sell.

Again, this is just an inevitable result of balancing supply and demand. While market makers are obligated to always state the prices at which they will buy and sell, they are not obligated to fill orders of any desired size – they are only obligated to meet what is known as normal market size. (NMS) for the stock in question, and for small, small-cap companies, this can be very small.

And that makes a lot of sense. If market makers were forced to fill orders of any size at the quoted price, this would imply that anyone wishing to take over the whole business could simply demand that market makers sell the whole thing to them. But obviously market makers can only sell the number of shares they can source themselves, and if there are few sellers, then a small order size is the best they can. make.

Supply and demand

With large companies, like the constituents of the FTSE-100, which are traded on the electronic SETS system, the normal market size is much larger than the example here. And thinking back to how SETS works, there are no human market makers in the middle, so when we want to buy shares, we can only buy at a price that other shareholders are willing to sell.

And that’s really all the market makers are trying to replicate. Rather than unfairly altering prices or restricting sales in order to maximize their own profits, what they try to do is to set prices at the levels necessary to balance supply and demand, in the same way that prices that SETS would produce by directly matching buyers and sellers (but with a larger spread, to cover their own profits).


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