Irish Eyes started his professional life as an accountant and so, by nature, veers towards the fundamental side of life.
Mind The Gap!
‘Mind the gap’ is the warning announced at all London Underground platforms as a tube train arrives or departs from a station. It refers to the gap between the platform and the train, and is broadcast loudly and incessantly at every station. Visitors to London who use the tube will have ‘Mind the gap’ still ringing in their ears long after they have arrived home. It is an essential part of the sound of that city.
A different sort of gap occurs on the stock market, but a ‘Mind the gap’ warning is not broadcast to traders. On the stock market we use the term ‘gap’ when referring to a situation where a share price opens at a different price to the closing price of the previous day. Some new investors and traders naively think that a share price opens every day at the same level it closed at on the previous day, and then proceeds to move up or down. That is most certainly not so. A share can open at any price at the start of trading.
Let’s take for example a fictional company which I shall call ‘Shakey Enterprises’. The shares close at £2.55 on Monday. On Tuesday morning, before the market opens at 8 am, Shakey Enterprises announce a profits warning stating that profits will be 20% below forecasts. At 8 am, Shakey Enterprises opens at £1.80 to £1.90, down 70p. They ‘gapped down’ traders will say.
Share prices are set by market-makers, who try to set a price where the level of demand and supply will be equal. The difference in the buy and sell price (known as the ‘bid’ and ‘offer’) is how they make their money. Therefore in the above example, the shares can be bought at £1.90 or sold at £1.80, from / to the market-maker.
If the market-makers opened the price at the £2.55 level, they would have a deluge of sell orders and would have to buy all of this stock. They would then be forced to cut the price to offload this stock, and incur serious losses in the process. So what happens is that the market-makers guess the price level where the sale orders (from investors who want to bail out), and the buy orders (from investors who believe the shares are good value after the fall) will be approximately equal. Their guess is that level is at £1.80/90. If they are right then some investors will sell their shares at that price, and other investors will buy at that price, and the market-maker makes 10 cents on every deal matched.
However, if the market makers have priced the shares at a level that is still too high (i.e. there are lots of sellers and very few buyers), then they will have to lower the price further. Alternatively, if they have lowered the opening price too much (i.e. there are far more buyers than sellers) then they will raise the price.
In practice, what I generally find is that the market-makers anticipate they will have more sellers than buyers in the above instance. They open the price sharply lower, take this stock on to their books, and then try to push the price up during the day as bargain hunters come in to buy from them.
Conversely, when a company announces good news, the marker-makers anticipate that they will have more buyers than sellers. They mark the share price sharply higher, sell stock at these high levels to investors, and then try to push the price down.
A trend will often develop in the first two hours of trading. Let’s say that in the above example the share rises to £2.05/6 after two hours trading. This usually means that the market-makers are long and are succeeding in pushing the share price upwards. My strategy is to jump in with them and also go long, and hopefully take profits towards the end of the session.
If however the shares fall further and are trading at £1.60/5 two hours later, this usually indicates that the market-makers did not cut the price by enough when they opened it at £1.60/5. I would jump in against them and go short at £1.80, and hopefully close out at a profit before close of trading.
It should be noted that the market-makers get it right more often than not, so the first example of possible trends, above, is more common, in my experience. All of this assumes that nothing else of significance happens during the day to change the level of demand or supply for the shares, and of course that is not always so.
So here are my rules for day trading, when a share gaps up or down at the open:
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1. When a share gaps down, the low for the day usually occurs during the first hour of trading. The shares then rally from that point, and close still down for the day, but well off the low.
2. Conversely, when a share gaps up, the high for the day will usually occur in the first hour of trading. The shares fall from that point, still closing up on the day, but well off the high.
3. When a share gaps down, and then continues to fall for the first two hours of trading, then it usually continues to fall for the remainder of the day.
4. When a share gaps up, and then continues to rise during the first two hours of trading, then it usually continues to rally for the remainder of the day.
5. The intra-day trend for Irish and UK stocks can be disrupted by the opening of the US market at 2.30 pm our time (9.30 am US Eastern time). If the US market opens sharply down, it usually depresses everything in Europe. And visa versa. Investors begin to anticipate how the US market will open from about 1 pm (our time) onwards.
6. The above rules also apply to the overall market i.e. the FTSE, Dow, S &P, Nasdaq etc.
There is no rule that works every time on the stock market!
August 15th, 2008 at 3:39 pm
Who are the market makers in the FTSE?
November 2nd, 2008 at 10:05 pm
Can you explain how the MM’s ‘push the price higher’ after selling the stock to people at a low price after bad news is announced and conversly how they ‘push the price back down’ after raising the price and flogging the shares to the public anfter a good news announcement…
November 1st, 2008 at 10:29 am
Hi Aaron
Sorry for the delay in replying … I’ve been travelling.
I think that the market makers in the FTSE future are Merrill Lynch, Goldman Sachs, Spear Leeds & Kellog, Societe General, Citigroup plus a few others. Also independent traders known as ‘locals’ sometimes act as market makers.
I have always dealt in FTSE futures through a broker, so I am not 100% certain that the above firms all act as market makers as I have never dealt with them directly. However Merrill, Goldman, Spear & Citigroup act as market makers for all of the stocks in the FTSE 100 index, so they are likely to act as market makers in the FTSE future as well.
November 4th, 2008 at 12:56 am
Hi Justsome1
The MMs push the price higher after buying (not selling) from the public at a low price after bad news is announced. The MMs anticipate heavy selling by investors and they mark the share price down to a very low level. Having bought these shares they then raise the price from this level during the day.
A good example of this is the price action on Elan shares when another case of PML was disclosed last week. The shares opened down about 50% but recovered during the day to close down approx 15%.
The reverse applies when good news is announced. The MMs know that many investors will rush to buy so they hike the price up. Investors blindly buy at this inflated price, and the MMs having sold shares to them mark the price downwards later on during the day.
Of course the MMs don’t always get it right, but in my experience this is the intra-day trend more often than not.
November 4th, 2008 at 2:15 pm
Irish Eyes,
Thanks for coming back to me. How do the MMs manage to push the price higher after buying from the public at a low price.
November 4th, 2008 at 5:48 pm
The MMs can quote any price they want for a share – to use the jargon, it is a ‘quote driven market’. ie it is the MMs who set the price. So they push the price higher by simply quoting a higher price.
The other type of market is an ‘order driven market’. In that type of market the price is determined by investors’ limit orders. Both types of markets exist side by side for the more popular shares. However at the opening of the market, there are usually very few limit orders from investors, and the MMs therefore have a much greater influence in setting the price.
In your other email you mention the MMs ‘running of stops’. This is also a factor in the intra day trend. For example let’s say that XYZ is trading at E5.50 /E5.54. The MMs see that there are a lot of buy orders in at a limit of E5.00. Some bad news emerges during the day that causes shares to fall (eg poor consumer confidence figures etc). This gives the MMs an excuse to mark the shares down to say E4.75 /E4.85, and take out the buy limit orders at E5.00. The MMs have then sold a lot of stock at E5.00 to these investors, and they buy back in at E4.75 from investors selling on reacting to this bad news.
Bear in mind that the MMs sometimes get it wrong and lose money. For example, the MMs open the price lower and investors are selling. The MMs then mark up the price but investors keep selling. This means that the MMs should have opened the price much lower that they did, so their day is off to a bad start!
After I wrote the ‘Mind the gap’ piece, I discovered a book called ‘The Trader’s Edge’ by Grant Noble. In it he describes a common intra day trend in futures markets which he calls ‘fading the opening’. This is the very same trend that I find occurs for shares, as set out in my article.
November 4th, 2008 at 8:06 pm
Irish Eyes,
Thank you for you informative email. I have learned a good bit from reading you articles.
Some further questions are coming to mind post your last email.
1. How does the market for a share start in the first place. Assume company ABC just IPO’d and wants to trade. A share price is set $20 based of fundamentals and a market maker is asked to trade the stock. Its 9am and the market opens what happens?? Does the market maker need to buy any shares himself to start the market or can he just go SHORT ABC off the bat if he is confronted with lots of buyers and no sellers. Wont he get stuck with alot of shares here ?
2. How can you have multiple market makers for the same stock in the pit or even different exchanges. If everyone is doing deals are different prices how does the price at any given time get set ?
3. If the share price is $20 and I go to buy 1 million shares, in reality what would actually happen ???
4. How is it that a market can both be a quote market and an order bid market at the same time. e.g how can something be traded by a market maker and at the same time be traded separately electronically.. Is there not a price discrepancy here ?
The S&P is pit trades and S&P mini’s is electronic…
5. I understand what you are saying about the market maker just moving the price up and down himself. However if the market maker moves the price from $5.50 down to $5 because he sees allot of stops there, does he have to buy / sell all the orders on the way down between $5.50 & $5 or can he just gap the market down…..
With the market maker moving the price I guess he moves the price to wherever he sees the most volume of trades taking place, as this will net him the most money in transactions commissions.
6. How does the price move in a electronic market, Assume bids are $5.00 and $5.05 asks are $5.10, $5.20, and i.e best bid-ask spread is 505 – 5.10. ( There are no matched orders). In this case who is going to move the price if there is no market maker.
7. If the quote market is bid 50 ask 55 and the market maker is forced to buy from you at 50, he is protected with the spread of 5, as long as he can sell it for more than 50 to someone else he’s making money. Suddenly a flood of sellers come into the market with no buyers. He’s going to need to drop the price otherwise he’ll get landed with the stock How does he protect himself past a drop of 45?. Can he hedge his position some other way..?
Any help appreciated.
Thanks
November 7th, 2008 at 4:48 am
Hi Justsome1
Answers to your questions below:-
1. The market maker has no stock when the market opens. Therefore he will have to go short if he is confronted with lots of buyers and no sellers. He will mark the price up to a very high level to protect himself, and he will also widen the spread. For example if the market maker had lots of buy orders and no sell orders at the open, he would open the price at something like $60 to $70. He sells to those buyers at $70 so he is short. He is now looking for sellers to come into the market when they see how high the price is. Sellers come in and he buys stock from them at $60. If buying and selling are about equal, the spread will narrow to say $64 / $65.
However if no sellers appear at this point, he will mark the price up further to say $90 to $105. If there are still no sellers, he will mark it up further, and also widen the spread. Rest assured that some of the investors who bought the stock in the IPO at $20 will be tempted to sell at some point.
Let’s take an extreme situation where absolutely no sellers appear. What the market maker will then do is that he will widen the spread to an absurdly wide level, maybe something like $150 to $200. Very few investors will buy or sell when the spread is so abnormally wide, so the market maker is effectively closing his book temporarily.
This kind of stuff did happen in the dot com boom. When investors are prepared to buy at any price, and nobody wants to sell, the market makers are very happy to sell that stock (and go short) to you at crazy prices. The market makers might have to stay short for a few weeks, but it will only be a matter of time before investors see that the market capitalisation cannot be justified, and the price collapses – to the market makers benefit.
More typically, the market makers discover the price where buying and selling are equal, and this happens very quickly. Let’s say the market maker opens the price at $22 to $23. The price stays at that level throughout the day and the volume of trading is very high. That means that the market maker has had a great day. He got the price right from the start, and took his spread between all those buys and sells. So if the price gyrates sharply during the day it menas that the market makers are having great difficulty pitching the price at the right level where buying and selling are equal.
And yes, market makers do sometimes go bust. They go short and eventually have to buy back at higher prices, or they go long and they have to sell at lower prices, thereby losing a stack of money.
2. Let’s say there are three market makers for a stock, and the market looks like this:
Mer 22.00 / 23.00 Gld
Gld 21.75 23.25 Mer
Blx 21.50 23.50 Blx
The above would appear on a level 2 pricing system. The share price is $22.00 to $23.00. If you want to sell, Mer is bidding the best price $22.00, so your broker will sell your stock to him. If you want to buy, Gld is offering the best price so your broker will buy the stock from him.
The above level 2 prices indicate that Mer wants to buy the stock (so he is currently short), and Gld wants to sell the stock (so he is currently long). Blx is staying out of the game by quoting prices which are worse than his competitors, so he doesn’t want to do anything for the moment.
3. It is only the institutions (ie fund managers, pension funds etc) that do orders of that size. Their broker will place the order to buy 1 million shares with a market maker that does block trades. The market maker will probably guarantee a part of the order at a price a bit above the current market price, and tells the broker he will ‘work’ the balance. So the market maker will try to gradually pick up the remainder of the stock in the market.
4. The market makers will usually match the best price on the competing order driven (electronic) system. If they refuse to do this and there is a discrepancy in price this will not last for long as traders will come in and buy on the cheaper market and sell on the dearer market.
5. The market maker will have to pick up all the orders on the way down from $5.50 to $5.00. So he sells to those investors who want to buy at $5.40, $5.30, $5.20 etc. He marks the price down to $5.00 and investors with stop losses at $5.00 will sell to him at that price. So the MM has sold at $5.40, $5.30, $5.20 etc and bought at $5.00.
Yes the market maker will move the price to where he sees the most transactions taking place. He makes his money on the spread, ie the difference between the buying and selling prices. It is the stockbroker who makes his money on the commission. There are three parties to every deal: the investor, his stockbroker (who executes the order with the MM) and the MM.
Spread betting firms cut the stockbroker out of the equation and deal directly with the market maker, but charge a wider spread than the market maker so the net effect for the investor is about the same. However you can start trading with a spread betting firm with a few hundred euro, whereas stockbroking firms usually have a minimum investment amount much higher than that.
6. The price will move when a big buyer or seller comes in. Let’s say a big buyer comes in and buys all the stock offered for sale at $5.10. He then buys all the stock for sale at $5.20. The price of the stock will now be $5.00 to $5.30, so the spread is abnormally wide. One of three things will happen next. Either the investor who is trying to buy at $5.00 will move his price up – to say $5.20. Or the seller at $5.30 moves his price down. Or new buyers and sellers appear who are prepared to trade between these prices.
7. Yes, the spread is the main way that the market maker is protected.
The other way the market maker is protected is that the price quoted is only for a limited number of shares. The price is quoted at 50 to 55. The normal market size is 1,000 shares. So the market maker is only compelled to trade at these prices for orders of up to 1,000 shares. A sell order comes in wanting to sell 2,000 shares – the MM quotes 49 for that. Another seller comes in trying to offload 20,000 shares – the MM quotes only 45 for that.
I know what you’re going to ask next. You’re going to say ‘If you have a big sell order, aren’t you better off selling it off in lots of 1,000, and you will get it all sold at a better price that way?’ No, because the MM will see what is happening here and will quote your broker a very poor price for any further sales. So brokers are obligated to tell the MM what they really have to sell (or buy) for their client.
Hope this answers your questions to your satisfaction.
November 8th, 2008 at 4:31 pm
This is fantastic information, How do you know all this stuff? On the many courses I have been on over the years, no trainer has ever been able to explain this to me… Is there any good blogs, web-sites, boosk, articles, where I can learn more how the actual market moves and the MM works. I am beginning to think of ways this MM process could be manipulated and would like to read more about the tricks people get up to….
Just two points to follow up.
Regards an investor asking to buy a million shares. Why would the market maker offer some shares above the current offer ??? and offer to ‘work the balance’ during the remainder of the day ???? Not clear on what the MM is trying to achieve here.
Also, from question 6. Assume no buyer or seller comes in and everyone is just sitting waiting in the electronic market. there is no agreement on bid-offers. Over in the quote market the MM will move the price up/down to “make the market”, but who will move the price on the electronic market? Does price only get moved by actual electronic orders agreeing or is there there a market maker here also to assist the market…?? OR will the electronic market just follow the pit traded market..
Finally where you decribered the 3 different market makers offering different bid-offers and who ever has the best bid or offer will be selected as the person people buy form… I can understand this fine.
However I have seen on TV, the CBOT where there are 50-100 traders in a PIT. How can the market work with 50-100 people making a market, or are these guys just trading the market via market makers …. and there was perhaps 1-2 market makers ? Not sure… I cant see how 50 guys can all make a living here as the only person with the best bid-ask at any time is in the game….
Thank you for taking the time and effort to explain this to me. you have been most helpful. I am much happier now than I understand what is happening here….
November 13th, 2008 at 12:49 am
Regarding the investors who wants to buy 1 million shares:
Let’s say the price is quoted at 550p to 552p.
550p is the bid price, and 552p is the offer price in this example.
The market maker is only obligated to trade a limited number of shares at these prices.
Let’s say that limited number is 50,000 shares.
So the market maker says to your broker:-
‘Ok, your client wants to buy 1 million shares. I can give you 250,000 at 555p and I will work the balance at that price or better.’
You will then see the price change to: 551p to 553p.
The market maker who sold the 250k shares to us at 555p, is now bidding 551p for the shares. Whatever amount he gets at that price, he sells to us at 555p. Also note that the market maker has pulled his offer of shares at 552p. He has raised his offer price to say 554p, and has let some other market maker offer ahead of him at 553p.
To use the jargon, the market maker who sold to us ‘is on the bid’ (and off the offer). This is because he wants to buy shares to, first, cover his short position of 250k, and second, to sell some more on to your broker at 555p.
The electronic offer market consists of investor buy and sell orders. If there are no buy and sell orders in this market, you will find that the market makers will quote a price (they must always quote a price) but the spread will be very wide. Eg in the above example, they might quote a spread of 545p to 565p. The spread will then narrow as buyers and sellers come in to the market. The market makers can put orders into the elecronic order driven system too if they wish. But mostly they compete with it, and usually quote prices slightly inside the spread on the electronic offer market.
When you see about 50 to 100 people in a trading pit (eg the S & P 500 index futures pit at CBOT), only a handful are making a market for large orders. The rest are small traders speculating with their own money. They have bought the right to trade in the pit by becoming members of the exchange, or by renting membership of the exchange.
Also note that there are some differences in terminology between Irl/Uk and the US. In the US, market makers are called specialists. In the Uk, market makers used to be called ‘jobbers’, but the ‘term market maker’ is nearly always used these days.
I can’t recommend any particular blog or website. Perhaps the paddypowertrader.com website will begin to fulfill that role as we put up more content, and answer customer questions.