NASDAQ Market maker/ NYSE specialist

[Yee Sian]

"On the Nasdaq brokerages act as market makers for various stocks. A market maker provides continuous bid and ask prices within a prescribed percentage spread for shares for which they are designated to make a market. They may match up buyers and sellers directly but usually they will maintain an inventory of shares to meet demands of investors." (Stocks Basics: How Stocks Trade)

May i ask what are these market makers? How do they operate?

From what i understand, their role is to make the market a more efficient one, by providing a continous flow of bid/ask prices. However, many market makers themselves usually have an inventory of shares for when supply greatly exceeds demand. So what happens when the market starts moving, and the prices of the inventory changes with the moving price, how does the market makers operate such that they don't lose out?

How does these market makers actually operate? Does anyone have a more intimate understanding of them? Sorry if im not very clear in the way i put my question across, this is quite new to me

[WallStGolfer31]

Market makers hedge with various other financial insturments such as options and off the books style, non-traded, insturments usually referred to as exotic derivatives, usually exotic options. By hedging their inventory, prices fluctuations will present little problems. Making a market is a privledge, and provides quite an porfitable experence for the firms that do so. Even if they dont hedge their inventoiry, which some don't (couldn't give you a figure on this most, little, who knows?) depending on their inventory turnover ratio, say it's 1/2 - 4 days, you might not need to hedge at all, depending on the stock. You can imagne stocks with very high volatility stocks, wuch as bio techs and energy, might be able to record an intraday turnover ratio, while low volatility stocks such as utilities might be turning over inventory every 2-5 days.

NYSE specialists are people that work for the exchange, and work on the floor of the exchange. They have unique knowledge about the daily volume nad price movements of the stocks they cover. They are used by insitiuions who are members of the NYSE (who hold a seat). By using one, a large order, such a say, a million share order, can take up to 30 mins, but you are trading off this time to get a lesser price range and less market impact on and from your order. Some say they are outdated, becasue there are many programs and people working at the firms themselves that can do the job equally as efficent as a NYSE floor specialist.

[Yee Sian]

Thanks Dann, you actually understood my question

Hmm, so some of them use hedges, while others that have a short turnover rate may think nothing to turning over their inventory frequently. As to the "exotic derivatives..." i suppose it's just too complicated for a simple mind like me right now to catch eh , just that it will end up benefitting the market makers?

Moving on from how these market makers operate, they put limit orders(bid/ask) out there to make the market more efficient? is there a fixed manner/pattern in which they do so, or is it up to their own interpretation of supply/demand for that certain stock?

ie. if the market price of a share is at $30, they may put bids out there for the shares at $29.95, and asks at $30.05. For example, if the prices of a stock is falling, market makers will put out more asks out there at prices lower than the market price than bids at prices higher than the market price, due to market forces. But how much more do they put? Is it up to their own interpretation/decision each time? Or do they have a certain strategy of doing so?

[WallStGolfer31]

For exotic derivatives, jsut think of a regular options contract with some conditions being changed. Maybe instead of expiring in June and representing 100 shares, you have a exotic that represents 10,980 shares expiring in June if they price is below 40 but if its above 40 then it expires in October. Just weird stuff like that that may look to have no use until you see what they are trying to do. They are just special contracts, usually negotiaged with insurance companies, who use other insturments to hedge what they are selling you to collect a premium. everybody wins

I wouldn't think market makers are constantly making money, that would be an unreasonable assumption. When a stocks dropping faster than my pants on prom night, you're usually going to loose money if you're not fully hedged, with a perfect hedge. This also applies to market makers. The main job of a market maker is to provide liquidity. Liquidity is the biggest risk and one of the big reasons we see 10% drops in MSFT, 30% Drops in Merck, etc. There are fundementals effecting the stocks , like mentioned before, but who is putting in a bid or buing ANY shares when Merck jsut announced Viox kills?!!?? Nobody buying, lots of people selling, plus the short sales, it's a liquidity problem. Market makers are the people who supply liquidity for stuff like missing same store sales doesn't result in a 30% loss, or beating eastimates by a penny doesn;t rack up 40%+ gains.


If you want to see what a market looks like without market makers, check out the pinks sheets and OTC's in detail. The erratic movement, even in those with relatively high volume, still have undesirable characteristics.


When you boil it all down, all actions of the market makers are two differnt things, first is their job, to provide liquidity in certain markets, and secondly, to make a profit.

[Yee Sian]

When a stocks dropping faster than my pants on prom night

Ahahaha. Ok, i caught your explanation on exotic derivatives, and i can see how it can benefit both sides

So market makers hedge to provide liquidity? If not, it can end up in the erratic movements seen in OTCs? When you say actions of the market makers is to make a profit, they do so by trading stocks themselves? These market makers can be trading institutions themselves, just that they have the special privilege of market making for the stockmarket ?

[FirstConsul]

They hedge not to lose money.
Suppose a market maker were long 100 call options with a delta of 0.4, 200 put options with a delta of -0.6, and long 1000 shares of the stock.
His total delta is 40-120+10=-70, so he needs to buy 7000 more shares of stock to hedge

[WallStGolfer31]

Originally Posted by Yee Sian

Ahahaha. Ok, i caught your explanation on exotic derivatives, and i can see how it can benefit both sides

So market makers hedge to provide liquidity? If not, it can end up in the erratic movements seen in OTCs? When you say actions of the market makers is to make a profit, they do so by trading stocks themselves? These market makers can be trading institutions themselves, just that they have the special privilege of market making for the stockmarket ?

no, they hedge for they can keep inventory price levels from being a concern. The market makers provide a bid and an ask when there are non present, and also contribute towards the bid and the ask when there is one. They also pay close to zilch commissions, and always sell at hte ask and buy at the bid. Taking the difference of the BA spread all year long will yield some nice *** cash. When there are enough buyers and sellers to create liquidity on their own, the market maker jsut acts as a middle man, scalping shares.