How to Play Market Maker Algos

ef818c5ea3dc847b4b7d4d990436a98c

What you see on your trading screen is not a complete view of what’s going on in the stock market. Behind the screen hard to comprehend forces are at work. These illusive aspects of the stock market include dark pools, high frequency trading, programmatic algorithms, and other technological innovations are designed for one reason…to take your money!

In this section I will discuss:

  • The role of the market maker in the stock market

Over the last decade one of the most fascinating technological advances in the stock market has been the replacement of human market makers with computers. A market maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security (a security can be a stock, option, future or another asset). Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds.

This is an example. The letters are the market maker firm or exchanges, i.e. PHLX.  The numbers are the amount of shares or options contracts they are offering. This is an example of an option spread.

bidask

As a day trader it is important to understand the role a market maker plays in the stock market. Market makers will display offers that do not always accurately reflect the “true price” which they are willing to buy and sell. These offers to buy and sell are displayed in the form of a bid and ask. Say you want to buy a stock, the ask price is the offer the market maker publicly displays as the price they are willing to sell to you. The bid price is the offer market makers publicly display as a price they are willing to buy at. This service provided by market maker firms offers liquidity to the stock market and helps facilitate transactions. Without market makers no stock market would exists. The buyers and sellers pay for this service when they transact in the market. Market makers can increase their profits by widening the spread between the bid and the ask price. Widening the spread helps market maker firms hide the “true price” they are willing to buy and sell at. It is imperative to be privy of this fact. I always try and pay less for these services. The goal is to discover the “true price” or best price the market maker is willing to give.

Colossal giants like Apple, Microsoft and Exxon are so heavily traded that the bid/ask spread usually reflects the true price the market maker is willing to buy and sell at. However, realizing the true price the market maker is willing to give is more difficult the smaller the company gets. Take for example the Chicago Mercantile Exchange company, symbol CME. This stock has a market cap of $32 billion and trades and average of 1.7 million shares a day. It’s not a small-cap stock but certainly doesn’t compare to Microsoft, a $430 billion dollar company that trades an average of 32 million shares a day.

In this section I discuss:

  • A “fat-finger” (accidental) trade that I managed for a small profit
  • Tips for order entry
  • How I discovered the “true price” the market makers were willing to give 

On March 18th I received an alert to buy CME because it was going higher. This was a red-hot alert and the signal told me to buy a lot and sell quickly. This was a scalp trade. The plan was to use highly leveraged options and sell them quickly (withing 5-10 minutes after buying). The problem was that my execution was horrible. Instead of buying call options I accidentally bought put options (Call options increase when the stock increases and put options increase when the stock decreases). I was tying to be quick and in doing so bought the wrong options. My poor execution put me in a hole as the price of the stock went immediately higher which was what my alert had told me would happen (see chart below).

cmechart2.PNG

When I bought the Put options the spread was $1.00 (bid) x $1.45 (ask) and the market maker filled me at $1.20. This was the “true price” the market maker was willing to give me.

  • Tip 1 – When I need my order to fill immediately and the stock isn’t moving in one direction with a lot of volatility, I find that submitting a “limit order” slightly above the ask sometimes gets me the “true price” the market maker is willing to give. I can’t tell you why offering to pay more than the ask gives me the “true price” but I believe it has something to do with the way the algorithm is programmed.
  • Tip 2 – I use “limit orders” because I want a cap on the amount I’m willing to pay for a stock or option. A “market order” tells the market maker that you are willing to buy or sell at any price they offer, and since they want to make money, and aren’t always the most ethical players, they will probably give you the best price according to them!

After accidentally buying the wrong options I immediately tried to sell but the stock went up, the spread dropped down to $0.85-$1.20. I was in the negative but what was worse is had I bought the right options I would have been sitting on a nice profit!

The price and chart action showed short-term resistance overhead. As the price started coming back down the bid stayed at $0.85 cents but the number of offers at $1.20 started to decrease. This was a sign that the market makers were getting ready to increase the spread. At this point it was a busted trade.  Instead of breaking-even I just wanted out so I submitted an order to sell some at $1.15. As soon as I submitted my order hundreds of market maker orders to sell at $1.15 matched me. Even though the stock was going down, and in my direction, the market makers were not going to let me get out easy, so they thought!

  • Tip 3 – I believe there are two apparent reasons why the market makers matched me at $1.15; if new buyers appeared they would sell from their own inventory instead of letting me sell, and they wanted me to capitulate and sell at a lower price.

What happens next is what led me to write this blog. CME continued heading down in my direction but the market makers didn’t want to let me sell the options at $1.15 so I cancelled my order because I knew that the “true price” was getting closer to the price I initially paid ($1.20).

  • Tip 4- To control order flow, market makers look for “real orders” from buyers and sellers. They like to anchor their bid and ask prices to these real orders. Cancelling my order took away their anchor.

My next step was to test the market makers and see where they were really willing to sell. I submitted an order to sell 10 contracts at $1.05 which immediately filled. The hundreds of market maker bids at $0.85 cents immediately rose to $1.05. This was a clear sign to me that the market makers wanted to buy at $1.05 and a “real order” from a buyer would not get filled at $1.05 unless the stock went back up.

  • Tip 5 – testing the market maker with small orders can force the algorithms to change their bids.

My next step was to see if I could sell at the price I paid, or better. I entered an order to sell 20 contracts at $1.20. The market maker algorithms did not match me this time and I was the only available ask at $1.20. The stock continued down but my options weren’t selling. This was not all that surprising to me.

  • Tip 6 – When your order is the only ask being offered and it doesn’t fill quickly when the stock is heading in your direction it is likely that the market maker is “holding” your order. This is so high frequency traders can take any on-coming order flow and trade ahead of you. Market maker firms and exchanges get paid by high frequency traders for order flow.
  • Tip 7 – my order to sell 20 contracts was the carrot I dangled for the market makers.

At this point I started moving my order up from $1.20 to $1.30. With my order resting at $1.30 it was time to test the algos again. This time I submitted another order to sell 10 contracts at $1.20. Then again another 10 contracts at $1.25. They both immediately filled!

  • Tip 8 – My test orders are smaller than the order I use as my carrot. This is to prevent spooking the exchanges from lowering their “true price” or best price, and keep them focused on the prize.

I moved my larger order up to $1.40 and was able to sell more at $1.30, then I cancelled my order at $1.40 and exited those for $1.30 for a net profit on the trade. This was at a point where the stock found a short-term bottom and headed back up. I was glad to be out of the trade.

Full disclosure of my trade below…

cmetrade

In this blog section I will discuss:

  • The psychology behind the trade:

I do not want to make it sound like manipulating the market maker algos is an easy task. Fact is there are many other aspects that can impact what the market maker is willing to show as the bid/ask offer. The lesson here is that the market makers display orders to buy and sell which do not always reflect the true price they are willing to give. One misconception about the stock market is that there are only two participants, one being a buyer and the other a seller. Truthfully, there are three participants. The third being market makers who are not usually speculating on a stocks direction but making money on the spread. These market makers will do whatever it takes to make money. The cost is absorbed by buyers who overpay and the sellers who capitulate. I still struggle with overpaying or selling to low. It’s not easy but it is something I continually look to improve upon.

Follow me on Twitter @ Jeffreytief

Check out my open trades here.

Check out my closed trader here.

 

 

Advertisements

One thought on “How to Play Market Maker Algos

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s