Marketmakers - NITE etc.
I come from a commodity background. I know quite well how the mechanism of the market works in commodities. I expect that they work in the same way in electronic stock trade. I will share what I know. The reason for this is that if the assumption that 'the market makers are playing games with us' is wrong, there may be some other conclusions to draw. Bear with me, this may be a long post.
Before going any further, I have seen crooked market makers. I know what they look like. IMO THIS IS NOT IT.
In commodities, there were people in the trading pit whose intent was to make one or two ticks (minimum price fluctuation) on every trade they handled. Then they intended to handle lots of trades. As members of the exchange, their trading costs were so minimal that it was more likely represented as a flat cost (i.e. membership fees and imputed interest on membership purchase). They were called Locals.
The service that the Locals provided to the market at large was that there was ALWAYS someone who would take the other side of the trade if you would meet their price. This let you enter or exit the market at will without waiting for someone to hit your bid/ask and hoping the market did not move materially away from your price.
For a local to make money, he/she had to sense what direction the volume was in. They make the most money by handling the most contracts so they are constantly looking for the prices that will create the most trades.
I learned the following analogy from someone reported to have made 200 million in the trading pits.
Think about the market as a faucet. If the price is fair, trades flow. At any given price, there are those who think the price is fair, those that think the price is too high, and those who think the price is too low. As the price shifts, the balance of those three categories changes. If the price gets too high, then the faucet of trades gets turned off because everyone thinks the price is too high. If the price gets too low, then faucet of trades gets turned off because everyone thinks the price is too low.
So the Locals would push the price back and forth searching for the high volume. When the price went too far, volume would dry up and then they would push the price in the other direction until they found the volume again. This is what creates the 'random walk' of an intraday chart. Market makers looking for the high volume prices.
Another participant in the pit was the brokerage house trader. His/Her job was to execute trades for the clients of the brokerage house. This trader would have a 'deck of orders' that they were trying to execute for the client. The contents of this deck would be closely held information so that the locals would not automatically 'know' where the volume was. This would give them an advantage over the brokerage clients.
So the Locals were pushing price around to see where the volume was in the brokerage 'decks'.
Things have changed with the advent of the electronic market. Today, the deck is transparent to the world with Level 2 Trading. You can see where the orders that are near the price lie. In a commodities trade L2, you can see the size of the orders. THE ONLY THING THAT BOTHERS ME ABOUT HOW THE MMs ARE HANDLING THIS STOCK IS THAT EVERY FRIGGING LINE OF THE L2 IS FOR 5000 SHARES. If we could actually see the volume of the orders that are waiting to be executed, we would know considerably more about what is really going on.
Yes, I believe that there are traders who are using signals embedded in stock sizes to facilitate larger orders. Yes, I believe there are traders who are selling small amounts against the bid to keep the chart down. I think these are shrewd traders. If you have never read it, you should really pick up a copy of 'Remaniscenses of a Stock Trader' by LeFebre. It will open your eyes to some things.
Lets say that you want to buy 300,000 shares of WAMU at 13 cents. Do you put in a bid for 300,000 shares of WAMU at 13 cents? NO WAY. If you do, then the bid will be at 13 1/2 and few if any will sell to you .
So what do you do?
You buy the ask (say 5000 shares at 12 1/2) and immediatly sell 500 at the bid (say 12). So now you hold 4500 shares at an average cost of
5000 * .125 = $625
500 * .12 = $60
4500 @ $565 = 0.12555555555 (repeating)
Then you wait a few minutes for the ask to replenish.
For a purchase of that size, you must be patient.
Now if it looks like the Judge is about to make a ruling, you get a little more impatient. You go ahead and put the order in for 300,000 shares and maybe 10% of it gets filled. Now you have 'swept the deck clean' at that price and your order is still sitting. Meanwhile, everyone else sees the huge volume and starts figuring they need to get in too. So they go meet the new bid and so on and so on and the next thing you know, you have spiked the price to 44 cents and tomorrow it will all come tumbling down.
The bottom line is that the MMs still have to fill their customer's orders. They also have respect the power of the market.
FINAL ANALYSIS
I am of the opinion that the bulk of the orders being processed are simply the orders of regular traders like us. I beleive that the market makers couldn't care less about keeping this stock down. There is simply not enough money at stake at these prices to be worth their while.
If they are accumulating stock, then they are no longer market makers and are now traders or investors like us.
Don't forget there are people who make their entire living 'flipping' stocks. Those are people doing this.
I have heard everything in the world about NITE. How evil they are. How they are controlled by JPM. How they are this and that. I have also heard (on this board) that they process the trades for Scottrade.
Maybe they are just one of the bigger players out there that have customers playing penny stocks. Maybe they look nefarious because there are a lot of people who bought at 1 or 2 cents and have decided to get out and move their money somewhere else.
Everyone works toward their own goals. Wouldn't the market makers do better in a stock that had more than 1/2 cent daily fluctuation and less than 5 million daily average volume. That is AT MOST $25,000 to be made in a day split among all of the market makers assuming they can sell at the absolute top and buy at the absolute bottom. It also assumes that the public are complete sheep and will blindly go along with what they want.
Not gonna happen.
FINAL FINAL ANALYSIS
We need to stop accusing the market makers of nefarious activity and start looking for reason why the 'market as a whole' is behaving this way. Understanding that will open the door to the other lesson I learned from the aforementioned commodities trader...
Figure out who is wrong and do the opposite.
I am long WAMUQ and long WAMPQ. I hope this puppy goes to the moon.
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