COMMENT
Market Maker Madness

By Ed Bowsher (TMFArkle) (TMFArkle)
October 6, 2005

Are market makers demons? Many private investors seem to think so. Apparently market makers move share prices for fun and shout for joy if they destroy the life savings of a hard working dentist in Tunbridge Wells.

I think this belief is largely a myth. Before I explain why, let's look at what market makers actually do.

In many ways, market makers are similar to wholesalers. Imagine you ran a newsagent in a world without wholesale. You would have to contact all the different newspaper publishers and make separate arrangements to buy their papers. And each publisher would have to operate its own distribution network. Wholesalers make life easier for all parties.

It's the same with market makers. If you're going to buy a share, you won't want to ring around all the shareholders and ask if they're willing to sell and at what price. Instead an investor normally approaches a broker (equivalent to the newsagent), and the broker will then approach the market maker.

Individual market makers normally cover a fairly small universe of stocks, and they are obliged to provide continuous buy and sell prices between 8am and 4:30pm.

Market makers keep a float of shares on their books so that they can easily meet small orders. If larger orders come in, they may need to find some sellers or buyers. The difference between the buy (offer) and the sell (bid) price (known as 'the spread') is market makers' main source of revenue.

The reason market makers arouse so much suspicion is because they set share prices and the spread. But they have less power than you might think. If a market maker suddenly receives several sell orders, there's a danger he will have too many shares on his book, so he will lower the bid to discourage sellers. If he wants to encourage buyers he will lower the offer.

Bulletin board posters often claim that share prices are falling because market makers are 'shaking the tree'. In other words, market makers are hoping to encourage sellers by lowering the bid price. The rationale is that shareholders will be scared by a falling share price, assume something is wrong with the company, and sell up.

I don't dispute that tree shaking happens, but you have to remember that it's a risky manoeuvre for the market maker. Sure, he may scare some shareholders into selling, but there's a good chance that demand for the stock will rise as traders scent a bargain. I don't believe that tree shaking is as widespread as some think.

And if a market maker does shake the tree, he probably won't be thinking: "Great, let's ruin some private punters this morning."

Market makers need private investors. Market makers make most money when they have lots of trades and when the share price is fairly static - reducing their risk. Private investors provide nice small trades that market makers can easily handle, so it's not in the market makers' interest to scare small investors away.

If you still think that market makers are sons of the devil, there's good news for you. They have been having a tough time in recent years. The largest 200 or so London stocks are now traded on SETS - a purely electronic system where market makers play no role. Many other stocks are traded on SETSmm, a hybrid market maker/electronic system.

One fund manager told me he's unhappy when a stock switches to SETS as electronic trading can increase share price volatility. He would rather use a market maker who can gradually acquire the shares as requested without moving the price so dramatically.

Reduced price volatility is good for the private investor too - certainly your blood pressure anyway.

I accept that private investors occasionally get caught out by some market maker manoeuvres. But there's a simple way to avoid that. Be confident in your original selection, and don't be distracted by short-term noise.

Confidence can come from the depth of your research. If you don't have the time to do some deep digging, why not consider a subscription to Champion Shares, the Motley Fool's new investment newsletter?

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