Reading Market Makers: The Signals They Send Each Other

May 05, 2016 4:18 PM ET1 Comment
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Long Only, Special Situations

Contributor Since 2011

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  • How some market makers use bid and ask amounts to signal each other.
  • Why market makers bid for 100 shares when they really want 25,000.
  • .

Many traders believe that market makers will "signal" moves in advance buy using small amounts of buys or sells as "signals". The "signals" are from one market maker to others.

100 I need shares.
200 I need shares badly, but do not take the stock down.
300 Take (or I am taking) the price down so I can load shares
400 Keep trading it sideways.
500 Gap the stock.

This is a theory put forth by a lot of penny stock and non-penny stock traders. This is not a guaranteed trading method but can lend some insight to market maker communications. It can pay to watch a few market makers of your favorite stock over several days or weeks to see if they follow these or other similar signals.

That way, you can divine what they are going to do and jump in ahead of any move that may come.

Why signals? Why not just message or email?

One simple reason; calling or emailing one or more of the other market makers and telling them to "take the price down" or "I am going to gap the stock" would be 100% illegal. It would be collusion at it's finest. If caught, handcuffs could replace their gold watch for a trip downtown.

Having worked on OTC/Agency (i.e. Nasdaq and OTC-BB) desks and worked with many actual market makers I've seen it all. I can attest that many market makers will use certain signals. Some will use fake bids/asks to trick individual investors and day-traders. They are still responsible for those bids/asks and would have to buy or sell there if their bid or ask is hit, but they post those to make others think they have an order and do not really want to buy or sell there.

Why 100 actually means 25,000

When watching larger stocks, market makers from large firms will often bid for 100 shares when they actually want several thousand shares.

Market makers are in the game to make money as well as execute orders for their firm's clients.

If you do see a huge bid or ask - thousands of shares where it's not usual it's often a fake. That is, they really don't want to execute that trade but are actually trying to scare others and to move the stock the opposite way that their bid or ask would indicate. If the stock happens to trade closer and closer to that larger bid or ask, it will disappear. Smaller stocks and penny stocks are rife with that type of dishonest manipulation on OTC markets.

Market makers will almost never show their hand to let others know what order they are working. For instance, let's say a market maker for at a major firm receives an order to purchase 25,000 shares of a stock at a $5.00 limit for an institutional client. He will never bid for the full 25,000. He will place a 100 or 200 share bid at $5.00 or lower. Why? If the market maker places all 25,000 shares at the bid at $5.00, another market maker with shares to sell could "hit" that bid and sell him everything at $5.00. The trade is over; the bidding market maker has just bought all 25,000 at $5.00. However, using smaller bids and some patience will usually mean he can get shares a bit cheaper. With a 25,000 order, a difference of just a few cents can result in thousands of dollars.

The market maker with the bid will put up only 100-200 to see if any fish bite. If they do, he'll remember who sold him those and move his bid down to $4.95, $4.90, etc. and see if he can get more there. If he does, great, he'll keep working the price down as far as he can go to get the shares as cheaply as possible.

Perhaps he now has 25,000 shares with an average price of $4.80. Now that the market maker has 25,000 shares, he can then sell them to his customer at $4.90. At $4.90, the customer is happy because he would have paid up to $5.00 and the market maker is happy because he sold the shares to the client $0.10 higher than it cost him and he made a tidy profit of $2,500.

Market makers will almost never post a bid or ask for more than just a few hundred shares no matter how large their true need is. So if you do see a market maker from a large firm posting a bid for 500 shares, there's usually thousands of shares behind that. Unless he's selling signals and not selling just stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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