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Beware of the Market Makers’ Trading Traps

Trading may be the ultimate “survival of the fittest” profession. No matter how good a trader you are – or how experienced you may be – there are always traders better than

Trading may be the ultimate “survival of the fittest” profession. No matter how good a trader you are – or how experienced you may be – there are always traders better than you. And, they’re looking to exploit you at any chance they get.

I’m most reminded of this harsh reality of trading life when I watch the action on my Level II screens. Day after day, uninitiated traders get deceived – and have their money taken away – by savvy, highly experienced market makers. Most of these new traders naively think just having access to Level II data is all they need to succeed – until they lose thousands upon thousands of dollars or just quit trading out of exasperation.

So, with that in mind, let’s look at some of the common tricks market makers unleash on unsuspecting souls – and see if you can save yourself some money the next time you trade.

To begin, in case you’re not familiar with Level II, it’s an electronic system that reveals a complex picture of what’s taking place under the surface of the market. It contains a list of potential buyers and sellers of stocks, including the bid and ask prices and the number of shares in each order.

Having this wealth and clarity of information at your fingertips can lead you to believe you have a firm grasp of what’s happening at the moment with a stock. And, this false sense of awareness is precisely what market makers thrive on.

They want you to buy or sell a stock at just the wrong moment – and they do it by making it appear you’re doing the “smart” thing.

When market makers seek to buy shares in a stock, they obviously want to get the cheapest price possible, to benefit either their clients or their own trading accounts. So, they create the illusion the stock is ready to drop by placing offers very close to the last selling price – and showing bids well beneath current levels.

This apparent lack of buying support leads the unwary to believe the price of the stock is about to go down – perhaps sharply – and that now would be an opportune time to sell. And, it also gives newbies the misguided idea that this would be a great chance to “front-end” the action and go short.

As both groups will find out later, this temporary downward pressure was just a “head fake” or trap used by market makers to spring shares at favorable prices from the uneducated. Once the market makers have fulfilled their orders, the alleged selling pressure will yield, the price of the stock will ease back up, and both the sellers and shorters will be grumbling at their screens.

When market makers want the price to go up so they can unload shares at the best prices possible, they’ll do just the opposite: They’ll create a false sense of underlying demand and an illusion of anxious buyers who just can’t wait to get in, which causes the price to rise. After the market makers have finished their selling, the price will drop to its “natural” levels.

Mind you, these aren’t huge movements in prices. But, they’re enough to allow market makers who execute such trades hundreds of times a day to generate significant amounts of profits. And, yes, market makers have the kind of clout necessary to make this happen – some of them work for the biggest financial firms in the world, like Goldman Sachs (GS) or Bear Sterns.

This sleight-of-hand by market makers occurs in practically all NASDAQ stocks, but is easier to detect in stocks trading under $30, and smaller-cap stocks.

Keep in mind that while you may think these sorts of activities are unfair, they are legal and they’re an everyday part of the financial markets.

While you can’t stop these tactics, you can learn more about how to avoid them – and even make money off them – by taking advantage of one of my free classes for new traders.

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