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Market Maker Tactics
The Smart Profits Report: Issue #205
Monday, May 2, 2005
Market Maker Tactics: What Market Makers Really Do
By Lee Lowell
Advisory Panelist, Mt. Vernon Research
Got a bad fill on a trade? Must’ve been the market maker tactics, ie. playing their games. Got filled on a stop loss right at the bottom, only to see the market turn around and go in your favor… without you?
Must’ve been the market makers playing their games again, right?
Well, I’m here to tell you that it’s not always the market makers who are playing the games. I should know: I was one of them.
For six years I slugged it out in the pits of the New York Mercantile Exchange (NYMEX). Being a market maker (or local, as we sometimes called each other) doesn’t always get you a good rap.
Let me give you the skinny on the life of one of these guys.
The Ultimate NYMEX Insider Speaks
The experiences that I recount here pertain to the pits of one of the largest commodities exchanges in the world, the NYMEX. While I’m convinced that most market makers play similar roles, I can’t speak for the guys who trade on the floors of the stock exchanges around the world.
- The NYMEX is a global center for the trading of energy futures and options. These energy contracts consist of such products as crude oil, heating oil, unleaded gasoline and natural gas.
- The NYMEX also houses the COMEX, which trades in metal futures and options consisting of gold, silver, platinum and palladium.
What Does A Market Maker Actually Do?
In the simplest terms, a market maker helps facilitate the execution of a trade by providing a continuous bid-and-ask market for a futures or options contract to any interested party.
You want to buy a futures contract for July Natural Gas? Who do you think gives your broker a quote for the most current price of that contract? Looking to get a market on the April Crude Oil $48/$49 call spread? It’s the market makers who provide you with a bid/ask quote on that call spread.
In stark contrast to how most off-floor retail players trade, the market makers usually don’t trade with a prediction about the direction of a particular market.
The market makers are purely there to try and buy a contract on their bid price, and then either try to sell that same contract on their offer price, or hedge their delta risk immediately if they can’t offset the original trade.
Relax… Most Market Maker Tactics Aren’t Out to “Get You”
When you ask your broker for a quote from the floor (which you should always do before placing ANY futures option trade), the market makers don’t know whether you want to buy or sell, so their tactics aren’t “out to get you.”
They don’t have a hidden agenda in which they try to rob you of all your money. In fact, the market makers try really hard to give good, accurate and fair quotes because, quite frankly, the ones who give the best markets are the ones who get involved with the most trades.
If you’re the type who gives very wide bid/ask quotes, or someone who doesn’t honor his markets if a broker wants to buy or sell from you, then you won’t be around for very long.
It’s a market maker’s job to be tactically involved with as many trades as possible, while getting a small edge with each one of those trades.
The tighter and fairer you make a quote, the more the brokers will trade with you. This is how market makers earn a living - by providing continuous, tight and fair quotes.
This Tactical Seat Costs $1.8 Million - Why Waste It?
It is a privilege to trade on any exchange. And in exchange for that privilege, the market makers must outright buy their own seat on that exchange, or they must lease a seat.
The last time I checked, a seat lease on the NYMEX cost about $17,000 a month, and a seat to buy cost $1.8 million! If you’re a market maker who leases a seat, you’re already in the hole $17,500 come the first of the month.
That’s a tough nut to crack month after month. And that’s why it’s in the best interests of the market makers tactics to provide a continuous flow of good, fair and quality quotes.
So the next time you get a bad fill on a trade, the market maker might not be to blame.
Good luck,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Check out the Smart Profits Glossary for defintions of words like “market maker” or “NYMEX” found in today’s article
- For more on the Market Maker series by Lee Lowell, check out Smart Profits #243, Market Maker Survival: The Options Pit “Caste System” Revealed.
Related Articles:
- Market Makers - Hand Signals, Stress and Million-Dollar Trades
- Options Market Makers: Two Rules for Beating the Market Makers
- How the Market Makers Lose: Uneven Trades and Open Positions
