Market makers make day trading exciting. They are dealers who buy and sell stocks on behalf of their clients or for their own firm. They provide liquidity for their customers and make the Nasdaq market viable. When a stock is liquid, it means the price will not be greatly changed by heavy buying or selling.
Market makers make money by capturing momentum moves. They also make money capturing the spread, just like NYSE specialists. Market makers also act as commissioned representatives for large financial firms or mutual funds. As reps, market makers become brokers acting on their client’s behalf to buy or sell a security. When market makers act as intermediaries for a big firm, they get paid a commission. The commission is usually the spread between the inside bid and the inside ask. In most cases, small orders from traders like you and me come from a market makers own inventory.
The term market maker refers to a securities firm as well as an individual. Examples are Goldman Sachs and Morgan Stanley, firms that are registered to buy and sell specific securities. As market makers, they abide by Nasdaq rules when making a market. Market makers are required by Nasdaq to maintain a two-sided market. This means they are required to post both a bid price and an ask price at the same time.
Unlike specialists and floor brokers, market makers work in offices, using computers and the telephone to make the market. One market maker may handle a single security or 25 at a time. There are approximately 60 market makers trading the 6,000 securities on Nasdaq. Usually, the big-name stocks have 40 or more market makers, while the smaller-name stocks have just a few.
Tracking and understanding their methods is vitally important for the day trader.
The Three Main Responsibilities of Market Makers
2. Keep an orderly market.
Different Types of Market Makers
It is important for day traders to be aware of the different types of market makers and understand the trading patterns they create. Here’s why:
Market makers do the lion’s share of trading on the OTC. Big market-making firms, such as Goldman Sachs, Paine Webber, Salomon Brothers, and Merrill Lynch, represent large institutions, such as pension funds and mutual funds. They buy and sell for these clients. They also trade for their own retail customers and their own trading accounts. The sheer volume of this trading can have a dramatic impact on stock prices.
You can watch market makers trading on what’s known as Level II computer screens. Patterns will emerge if you watch them over time. They repeat certain actions throughout the day, giving you insight into their true buy and sell intentions and market direction.
Keep in mind that market makers do not always make the right decisions. The market as a whole is always more powerful than any single market maker.