Whenever you buy or sell a stock, there’s always someone on the other side, selling to you or buying from you – but who is that person?
More importantly, what’s his or her role, and what’s the guiding principal that has led that person to take the position?
When you want to buy or sell a stock, you need someone to facilitate the transaction. Have you ever thought about what might happen if you want to sell, but there’s no buyer? At what price would the sale order be executed? Enter the market maker.
Market makers are the people always willing to fulfill the role of “the other party,” even if they don’t buy and sell the way you do. Their role is to constantly stand behind the stock. They set “buy” and “sell” orders in advance, with fixed spreads – hence, they “make the market” for that stock.
How Do Market Makers Profit?
The profit for a market maker derives from the spread (the difference) between the sale and purchase prices. For a company with a volume of millions of stocks per day, a profit of one cent can amount to $10,000 per day for every million shares traded. Not a bad income at all!
Of course, it’s not always that simple in the market makers’ world. They take no small amount of risk, in that the stock moves in the opposite direction from the actions they execute. On the NASDAQ exchange, to ensure that the market will remain competitive and that the spreads set by the market makers will remain as limited as possible, the stock exchange encourages activity by a large number of market makers for the same stock. When a specific stock is being handled by dozens of market makers, the individual investor is assured of high volume and competitive spreads.
Specialists are the NYSE’s version of NASDAQ’s market makers. In contrast to the NASDAQ, in the NYSE each stock is allocated to only one specialist. The specialist might be allocated several stocks to trade simultaneously, but each stock will only be traded by that one single specialist.
The Dual Role of Specialists
Specialists hold two roles for the markets:
1) They must provide reasonable liquidity when there are no buyers or sellers for the stock, by buying and selling to their own accounts. This prevents fluctuation during periods when there are no other buyers or sellers.
2) They serve as brokers for the brokers by setting buy and sell orders and carrying them out at the best price possible, known as “best execution.” For example, if a certain broker is interested in executing a sell order for a client for a stock priced at $50, but the client’s order is to buy at $49 in the hope that the stock will drop to this level, the specialist keeps the order on his or her book, called “booking the order,” and executes the order when the price reaches the client’s preferred level.
The law requires that specialists must respect the client’s interests over their own at all times. Until only a few years ago, before the markets went almost entirely digital, every buy and sell order went through a specialist. Today, most NYSE executions take place via automated trading, similar to the NASDAQ format.
The ECN Revolution
By now, it should be clear that the role of market makers and specialists is important, but you may also be asking “How do they make their money?” Well, don’t feel too badly for them – market makers and specialists profit from the spread between the bid and ask, which means that we the traders provide their compensation.
An ECN (Electronic Communication Network) allows us to forego their intermediate services. The ECN is a network of computers that allows buyers and sellers to connect and set buy and sell orders without the “mediation” of market makers. ECNs began operations in 1969, with the very first system known as “Instinet,” which initially was used only by the market makers for transactions between each other.
Due to the lack of liquidity that led to the 1987 collapse, laws were passed that forced market makers to respect electronic orders. These laws saw the first usage of ECN systems by the public. Currently, the majority of orders we execute are placed through ECNs.
Stock traders, in contrast to investors, use “Direct Access” trading programs, which we’ll study later on. Through direct access programs, we can choose to send buy or sell orders directly to market makers, or to the range of ECN systems. Another popular option is to use the services of a broker, who will automatically choose the most suitable direct access channel for you in terms of execution speed and cost.
How is All This Connected to You?
At the basic level, it doesn’t…but that doesn’t mean it isn’t helpful to know! Since you’re putting your own money on the line, it’s important to have at least a basic understanding of how the markets work.
If you are a modest retail investor, you can open an account with a broker, deposit your money, and learn how to buy and sell stocks, and as long as you're trading only in small quantities of several hundred shares per click, you can use your broker’s auto-routing and ignore all the background activity. When you develop into a more serious trader and increase your quantities, known as positions, to thousands of shares per click, you'll come across instances where you'll receive only part of the quantities you require (partial executions), and often at prices higher than you wished. For large positions, it’s worth routing your orders to different destinations in order to gain speed and liquidity. Of course, it will take some time to get to that stage, and by then you will be far more familiar with the additional routing options and their significance.
To learn more about the stock market and to begin your own journey toward financial independence, visit Meir Barak's site Tradenet and check out his book "The Market Whisperer".
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