Market Makers

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

Imagine a situation in which a company comes out with some good news — be it great results, updated forecasts, news of a big contract, or whatever — and a lot of people want to get in quick, before the price rises. As soon as the market doors are open, legions of investors pile in and start asking their brokers for quotes. But the price has already gone up, and people complain that the market makers have cheated by marking the price up before any trading has taken place.

Misunderstandings

Those complaints are based on a couple of related misunderstandings. Firstly, when the market opens, a share does not have to start at the same price it closed at the previous day, so there is nothing devious at all in marking up the price before opening. Also, people often fail to understand that the prices quoted by market makers at any one time reflect the balance of supply and demand at that time, and they have to pitch their prices so as to be able to both buy and sell the shares.

If a market maker knew that, say, a company had reported earnings 10% better than expected, and opened his books at the closing prices from the previous evening, he simply wouldn’t get anyone willing to sell shares (because potential sellers will have heard the good news too), and so he couldn’t offer any for us to buy — market makers tend to keep a relatively small float of shares, which would be depleted almost immediately.

So if it appears that a market maker might be trying to stitch you up by instantly bumping his prices by 10% when you want to buy some, it’s because he’ll also be having to pay 10% more to entice anyone to sell to him.

Can’t buy enough?

A related complaint, when a share price is rising, is that it is impossible to buy any decent amount of the shares, and we hear complaints that market makers are holding back the shares, or hoarding them, waiting for them to go even higher before they sell.

Again, this is just an inevitable result of the balance of supply and demand. While market makers are obliged to always quote prices that they will buy and sell at, they are not obliged to satisfy orders of any desired size — they are only obliged to meet what is known as the Normal Market Size (NMS) for the stock in question, and for small and thinly traded companies, that can be very small indeed.

And it makes a lot of sense. If market makers were obliged to fulfil orders of any size at the stated price, that would imply that anyone wanting to take over the whole company could just demand that the market makers sell all of it to them. But obviously, market makers can only sell the number of shares that they can get hold of themselves, and if there are few sellers, then a small order size is the best they can do.

Supply and demand

With larger companies, like FTSE-100 constituents, which are traded on the electronic SETS system, the normal market sizes are vastly larger than the example here. And casting our minds 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 at.

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


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