Can Market Makers actually lose money being the middleman?

[Mbrown10012]

I understand Market Makers profit off the bid/ask pricing. If the bid is 15.02 and the ask is 15.04, they'll buy it for 15.02 and sell it for 15.04. By creating a wider spread, it will create a higher profit margin.

When there is more buyers than sellers, they will boost up the bid/ask and when there is more sellers, they'll lower the bid/ask. Basically all they do is price match all day looking for the best fit while trying to create the largest spreads. However, I don't think its possible to see wide spreads in high volume stocks since there is usually more than one market maker compared to penny stocks.

With them knowing where the supply/demand is headed, I'll try to create a scenario. With the standard concept of moving average, support and resistance. Market makers knows where all the stop loss will be at and if there are any buy orders under a certain prices. Since they know where everybody will sell at with hard stops, and they know where the majority will buy at, can't they purchase the initial supply before letting the crowd get into the action?

Basically with them knowing the supply/demand through orders waiting to get filled, they can get the first piece of action before committing while riding the wave.


This is just a theory, some say market makers don't care where your order is at, but most of the selling and buying will definitely be at crucial levels like support/resistance which they can profit from. Also this only applies to low volume stocks since stocks like MSFT will have like 30 market makers.

[Albert0373]

Good info here: http://www.optiontradingpedia.com/market_makers.htm

Risks That Market Makers Face
Market Makers for stock options trading faces 6 forms of risks which, in fact, all option traders face :

1. Directional Risk / Delta Risk
Directional or Delta risk is the risk that a stock option price will turn against the market maker as the underlying stock value changes. A Market Maker consistent attempts to hedge this risk by going "Delta-Neutral".

2. Gamma Risk
Gamma risk is the risk that the delta value of a stock option may change over time. This consistently threatens to tip a Market Maker's sensitive Delta-Neutral position to become of positive or negative delta, thereby exposing a Market Maker to directional risk. Gamma risk can be overcome by taking Gamma Neutral Positions.

3. Volatility Risk
An increase in implied volatility in the market increases the premium value of stock options while a decrease in implied volatility decreases the premium value of stock options due. This is known as the Vega risk. Market Makers who hold an inventory of stock options could sustain a loss if implied volatility decreases.

4. Time Decay Risk
Time Decay or Theta risk is when stock option premium reduces as expiration date draws nearer even if the underlying stock does not move. A Market Maker with an inventory of long stock options can sustain a loss over time even if the underlying stock does not move.

5. Interest Rate Risk
Stock options, especially long term ones, are affected slightly by changes in interest rates. This change, although insignificant to most option traders, is significant to Market Makers who hold very large inventory of stock options. This risk is represented by the Options Rho.

6. Dividend Risk
Dividends declared reduces call option value as holder of the call option do not recieve the dividends. Such risks are usually hedged by Market Makers by buying the underlying stock ahead of it's dividend declaration. The dividends recieved then hedge against the decline in call option value.

Unlike independant option traders, Market Makers cannot sell off their inventory of stock options simply because they know these stock options are going to go down in value due to any of the above risks, that is why hedging is such an important skill to Market Makers.

[Mbrown10012]

Thanks, this will give more a better insight.

[Bolimomo]

I don't have any first hand knowledge. Most about Market Makers is what I read from books and articles and video clips.

MM has two advantages over us retails:
1) They can see the order book (limit order, stop orders).
2) They have institutional orders.

If mutual fund manager A decides to buy 300,000 shares of CSCO today, around the price of $18.30, and he gives the order to MM Joe. Now Joe knows the "support" price for CSCO. To him, it's somewhere below 18.30. He can snap up all the sell orders below 18.30. Of course his incentive would be to buy as low a price as possible. The lower his VWAP is, the higher his profit margin is. Sometimes he may play scare tactics. He can post a big sell order on Level 2 where everybody sees... that MM Joe has 100,000 shares to sell at 18.40, and create some smoke and mirror "selling pressure". But in reality he might use ECNs to collect lots of shares from the retails.

Though they are probably among the best traders in the market, I tend to think that there are times they got it wrong too. Even the best traders make bad trades sometimes. I am sure they have bad days just like the rest of us. But probably not too many.

In today's market (penny spread), it's unlikely that the current inside market (best bid/best ask) is offered by the same market maker. For example, if the inside market for CSCO is 18.30-bid, 18.31-ask, it's very unlikely that it is posted by the same MM Joe. It's more likely MM Joe is bidding at 18.30 (and offering at 18.40), and MM Bob is offering at 18.31 (and bidding at 18.21).

[Mbrown10012]

Thanks boli, your post was indeed helpful. I was looking for exactly what you posted. Thanks!