How Market Makers' Interests are Aligned with Yours

Don’t be like Joe.

Joe wants to go long at 1.0051 and has his limit order to do so in the market. His order is the highest bid. Bob wants to sell and sell fast so he enters a market order to sell at market. The market maker fills his order to sell at 1.0052 and blocks Joe’s order. Joe is not happy. But what about Bob? Is Bob bummed he got paid a little extra from the market maker? Heck no, he is in a good psychological place. He is loving what he was served.

Ben wants to go short at 1.0054 and has a limit order to do so in the market. His order is the lowest ask. Jim wants to buy and buy fast so he enters a market order to buy at market. The market maker fills his order to buy at 1.0053 and blocks Ben’s order. Ben is not happy. But what about Jim? Is Jim bummed he paid a little less to the market maker?

After a while, Ben and Joe finally get sick of waiting and cancel their limit orders and enter market orders. The market maker fills Joe at 1.0053 and Ben at 1.0052. Joe paid two more pips than he wanted but still paid 1 pip less than what Ben would have filled him at. Ben got two pips less than what he wanted but still got 1 pip more than what Joe would have filled him at. Which of them are mad at the market maker now?

If it is in the interest of a trader to get quick execution at the best price available then his interests are ALIGNED with the market maker (not conflicting). The market maker benefits by trading between the bid and ask offered in the order flow. When the market maker bought from Bob at 1.0052 and sold to Jim at 1.0053 he made a pip. When he bought from Ben at 1.0052 and sold to Joe at 1.0053 he made another pip. The market maker got everyone to work with him by offering a savings to every party. For this, he got to keep some of the savings as his profit.

Joe doesn’t understand all of this. Joe calls himself a “scalper”. Joe wanted to buy at 1.0051 and then turn around and sell at 1.0052 and make a pip (Joe thinks he can be a market maker without seeing the order flow or having the capacity to fill orders that the market maker has). But he got tired of waiting and bought from the market maker at 1.0053 because he thinks the market will bump up a pip anyway. Now he is trying to sell at 1.0054 and buyers keep buying from the market maker at 1.0053. Suddenly, a string of sellers come along willing to sell at 1.0052 and the highest bid is only 1.0050 so the market maker starts filling market sells at 1.0051 and lets the market buy orders fill at 1.0052 against the sellers. Joe is bummed even more to see people buying at 1.0052 after he just bought for 1.0053. He moves his sell to 1.0052 to try to lose just one pip and waits a long time as all the other sellers get filled. Then he sees the bid drop to 1.0050 and panics and sells at market. The market maker fills his order at 1.0050. He lost 3 pips. He just knows that mean old market maker took his money.

But did the market maker take his money? When Joe bought at 1.0053 the market maker went short. But the market maker covered at 1.0052 a minute later while Joe was still waiting to sell. The market maker made 1 pip. Then, when Joe finally sold, he sold to the market maker at 1.0050 and the market maker was actually covering a short that made him one pip. So who did the market maker make those two pips from? And if the market maker made them off of Joe and made just two pips and Joe lost 3, where did his other pip go? Joe is mad because he is sure that his little plan to make the spread would have profited if the market maker wasn’t out to get him.

Then, an avalanche of orders come into the market on surprise news. The market maker, up 20 pips for the day, suddenly gets caught holding a position that loses him 19 pips and he is back down to just one pip. Who won the market maker’s pips? Joe is sure the market maker is killing it and Joe is his target. Joe has no idea what the market maker is going through or who the other buyers and sellers are or their circumstances. But he knows that behind all that lack of information is the money he lost and there must be an enemy secretly lurking. He saw a Youtube video that showed how evil the market makers are so he knows that it must be him… …or her… …or it (a computer).

Don’t be like Joe.

Joe heard that market makers run stops and collect losses. He doesn’t know what that means really. He just heard that the market maker can control the price and get it to go down to his stop to bag his loss. That is why he doesn’t use stop loss orders. That way the market maker cannot see his stop order.

What Joe doesn’t know is just how unprofitable it would be for the market maker to suddenly start selling into buyers to bring the price down to his stop. What he also doesn’t know is that if there are no buyers for the market maker to sell through to get to his stop then it is not the market maker that is moving the price but the market.

Joe hears from an arbitrager on acid that he should not worry about stops getting run through by the market maker and that he should rest easy and put a stop loss order in the market. After some thought, Joe puts on another order to buy at 1.0040 with a stop at 1.0035. He is sure that the recent drop means things will bounce back up. What he doesn’t know is that there are hundreds of thousands of units worth in limit orders to buy at 1.0039. The market maker lets a market order to sell fill Joe’s buy at 1.0040

Soon Joe sees the bid drop to 1.0039 and there it stays for a long time. The market maker, holding a net long position left over from the recent heavy selling, allows the market orders to sell to get filled by those limit orders at 1.0039. Meanwhile the market maker slowly unwinds his long position by filling market orders to buy at 1.0041 and then later when limit orders to sell at 1.0041 arrive he continues selling at 1.0040. Soon the market maker is flat again.

Joe starts to worry. He is sure the market maker is going to push the price down to stop him out at 1.0035. More limit orders to sell come in to the market maker at 1.0040 and the market maker sits back as the spread remains 1.0039 by 1.0040 for a long time. Then the 1.0039 limit orders run out and more market orders come in. The market maker starts buying again at 1.0037 and starts selling at 1.0039. Then the market orders drop to 1.0039 so the market maker sells at 1.0038. Joe just knows that the big seller in this market HAS to be that evil market maker.

Then, everything changes. A demon possesses the market maker. His eyes turn to blood and horns rise from his scalp. He starts gunning for Joe’s stop! There are thousands of units in limit orders to buy at 1.0036 and the market maker just starts filling them. He covers his recent buys from 1.0037 at 1.0036 losing pips in the process and then once he has filled all the 1.0036 orders to buy and has a big short position he starts selling into the 1.0035 limit orders triggering and filling Joe’s stop too! With no more buyers left at 1.0035 the market maker sets the bid at 1.0035 hoping to break even on the 1.0035 fills and eventually move on to some profits but there are no sellers. The market sell orders are dried up.

The market maker suddenly starts to snap out of it. He realizes he is really short and there are no other sellers this low! His horns retreat and his eyes and knuckles turn white as he starts to raise his bid. 1.0036? 1.0037? Where did everyone go?" He thinks. Panicking he raises the bid 1.0038? He buys a few at 1.0038. 1.0039? He buys a few more at 1.0039. Finally 1.0040. He starts liquidating his shorts that he entered at 1.0036 and 1.0035 at 1.0040 for a big loss.

At the end of the session the market maker’s boss looks at the records of all of this and says: “What the hell happened? You sold into the limit buys and lost big?!? Are you possessed?!” The market maker replied: “Look here. You see Joe’s trade? We got his stop!” “But Joe is scalping in a $200 retail account you idiot!” exclaimed the boss. “You lost thousands!”

Then, suddenly, Joe woke up staring at his computer. It was all a dream and he is still long from 1.0040 with the current bid at 1.0040 and ask at 1.0041. He enters a market order to sell and is filled by the market maker at 1.0040 for a breakeven end to the day.

Don’t be like Joe.

-Adrian

Nice that everything turned out ok for Bob lol

both education and poetic! thanks for the post!