Trading Is There Money In Being A Market Maker?

OK so I'm generally the first person to say that trading is a terrible way to make money for 97% of people, so I do see a bit of irony in me posting a thread about being a market maker. Anyway...

So I have been acquiring shares in a small cap company over the last 6 months, and like most small cap companies it isn't very liquid, and at times bid and ask spreads can get quite high, up to 5 - 10%. So I can't help but feel like there is a bit of an opportunity here and I'm kind of hoping someone can highlight me to the pitfalls of being a market maker and talk me out of it so I can keep telling people trading is just a way to lose money for 95%of people...



Anyway I'll throw a hypothetical scenario at you guys so you can let me know what you think.

OK as mentioned, I have been acquiring shares in a company, for simplicities sake let's say I have 100,000 so far and they have been acquired at an average cost of $0.45 over the last months.

Now I'm acquiring this company because I think it's good value and I do have intention of buying/holding more stock in it if subsequent news and reports are inline with projections and let's say, if those projections are realised that I think this company's fair value is around $1.25.

So what I'm trying to say is that my first focus is to be accumulating shares in this company so I don't mind if I'm playing both sides of the trade, ie both buying more from people looking to liquidate as well as and being a market maker as I procure more shares.

Now let say the last batch of shares I acquired was yesterday at $0.49 with a limit order, but the share has been trending up but of late has been around the $0.50 mark.

Now let's say after fulfilling my limit order yesterday at $0.49 the current bid is $0.48 and the ask is $0.53.

So by my logic given I just procured 10,000 share yesterday, if I was to place a sell order for $0.525 and it was fulfilled the profit I would make would be $0.525 - $0.49 x 10,000 - brokerage fee (2 x $25) which would equal $300 profit for doing essentially being willing to buy and sell with limits instead of at market.

And at the same time I can place a $0.485 buy order in case anyone is looking to liquidate their holdings so at the same time I could start accumulating shares in this company (which is what I want to do anyway) at a lower price than market.

Is this logic flawed in any way?

I know it's not quite that easy as that and that the market can move against me, in that if I set a buy price at say $0.48 then the the order is fulfilled and then the price continues to move lower to say $0.45 the sell order I had a $0.525 might quickly become unrealistic as people begin to offer to sell for lower and supersede my offer.

Also I know that this sort of strategy requires patience and won't be a big money spinner, ie in this particular stock there are normally only 1 or 2 trades a day max, and I would say trades are only made 1 in every 2 days, with the average volume being around 5,000 to 10,000.

With that said, my logic is that I'm "somewhat" protected because I do actually want to acquire the company over time so accumulating stock by setting bid limits should help me dollar cost average in, and I can't lose money if I sell the stock higher than what I bought it for by offering a sell order at a limit. If the price falls I lower my average cost of acquisition, if the price rises I'm selling for a profit, plus my remaining shares have gone up in value. Right?

Anyway moving onto some questions I have:

So what are the downsides of this strategy that I'm not seeing?

If I was to do something like this does anyone have any tips?

What's most cost effective way of implementing this strategy? I'm assuming brokerage is the main killer.

Also what happens when only half an order is fulfilled and the market moves, ie if I place a buy order for 10,000 shares and someone only sells 2000 of them and then the rest of the limit order is never fulfilled? What happens and how is brokerage charged in this case?

Also do lots of people do this sort of thing for low cap, illiquid stocks? If not, why not?

What other questions should I be asking?

Thanks in advance.

 

I would say that 80% are losing money, because people involved in this business do not have certain rules/system in place and are not prepared to improve own ability to become successful.
But if your win/loss ratio is at least 2:1 or better, you can sleep well.

Do not confuse market makers with traders/investors.
Basic info is here... What is a Market Maker and How do Market Makers Make Money

You are never protected a 100%.
Averaging down is a mistake. You are practically increasing your loss with time, and stock you are buying may never recover (eg. HIH, Enron ect...).
Never touch illiquid stocks !!
There may be a lot of reasons why such stock is illiquid, so if you are forced to sell, you may have a problem.
There are few books which may give you an answer to your questions, so why don't you read some of them?

 

But this is exactly what I would be doing...

A market maker is a bank or brokerage company that stands ready every second of the trading day with a firm ask and bid price.

As in the above example, if the spread is really wide on the stock people might be unwilling to sell or buy so I would put in a bid and ask price that would narrow the spread, to allow buyers/seller to trade. Whilst I wouldn't be really making a market, because there is other willing buyers and sellers, I would be narrowing the spreads for everyone.

That said, at an given time there are usually only 3 - 5 people with sell and buy limit orders on this stock, which can get a low as 1 from time to time. So I just thought there was an opportunity to make the market a bit more liquid and make money on the spread?

Am I wrong?

Like I said, my TRUE intention is to acquire stock over time. Being a market maker is just something I'd do in the interim.

I'm not too worried about this company going bust. It's been in business for decades, has no debt, and a pretty simple simple business model and has plenty of assets to sell if it does go belly up.

Like I said I'm really buying this company because I think it offers good value, ie I'm buying it for its future earnings. So from my perspective averaging down would be a dream as it is a way to maximise my return.

My logic is they are only bad if you need to sell out of your position quickly.

As I said, I'm quite happy to acquire more over time and I'm approaching this with the understanding this strategy requires patience, with a prospective investment time frame of forever.

I'm always taking book recommendations... so feel free to recommend.

I actually, took a note to buy the book, Market Wizards, after your posting of Jack Schwager's video.

Figured I should at least learn about the dark side, given I generally badmouth it so much.

 

"But this is exactly what I would be doing...

A market maker is a bank or brokerage company that stands ready every second of the trading day with a firm ask and bid price.

As in the above example, if the spread is really wide on the stock people might be unwilling to sell or buy so I would put in a bid and ask price that would narrow the spread, to allow buyers/seller to trade. Whilst I wouldn't be really making a market, because there is other willing buyers and sellers, I would be narrowing the spreads for everyone.

That said, at an given time there are usually only 3 - 5 people with sell and buy limit orders on this stock, which can get a low as 1 from time to time. So I just thought there was an opportunity to make the market a bit more liquid and make money on the spread?

Am I wrong?"

If spread is tight you may attract more buyers/sellers.
Actually in FX market there are more platforms where spread is 1 pip on majors.
You cannot predict how many buyers/sellers would be at any time.
There are also people who buying at market price (not only players with a limit orders).
So, spread is your income.
Market makers also make money running stops from time to time (depends which market we are talking about).
Volume is very important. If you have got only few buyers/sellers, you may quickly go out of business.

"Like I said, my TRUE intention is to acquire stock over time. Being a market maker is just something I'd do in the interim.

I'm not too worried about this company going bust. It's been in business for decades, has no debt, and a pretty simple simple business model and has plenty of assets to sell if it does go belly up.

Like I said I'm really buying this company because I think it offers good value, ie I'm buying it for its future earnings. So from my perspective averaging down would be a dream as it is a way to maximise my return."

I can't see any logic in it...
You don't need to be a market maker to acquire stock over time.
Nobody can predict future earnings like nobody can predict where market can be in the future.
You can estimate, but you can be dead wrong.
There was a lot of very good companies in the past....Problem was, that those companies represented "value" but only on paper (Enron, HIH etc...).
In my view, majority of company reports, earnings etc...are not giving you right picture, so relying only on information which is mainly made up is a very dangerous game.
I don't remember name, but there was one trader who by averaging down, almost bankrupt the bank.
I am not sure where you are getting your idea from, but I would not do it !!!

"My logic is they are only bad if you need to sell out of your position quickly.
As I said, I'm quite happy to acquire more over time and I'm approaching this with the understanding this strategy requires patience, with a prospective investment time frame of forever"

Not necessarily.
You may be forced to sell for whatever reason.
After all you are buying shares to make some money out of it...
As long as you are not selling, your profit is a pure illusion (assuming that you sell with profit).
There is nothing wrong with accumulation, if stock is moving in your "direction" (down or up). But at one stage, may be a time to sell.

"I'm always taking book recommendations... so feel free to recommend.

I actually, took a note to buy the book, Market Wizards, after your posting of Jack Schwager's video.

Figured I should at least learn about the dark side, given I generally badmouth it so much."

Always learn from the best !!!!!!!!!!
Without knowledge, you are not going to make it.
So...before you make first move I would strongly recommend two books:
1) Market Wizards - by J. Schwager
2) The New Market Wizards - conversations with America's top traders - by J. Schwager

Have fun...

 

I just want to preface by saying I really appreciate the response.

I honestly started this thread because I wanted some constructive criticism about an idea. So I appreciate you playing devils advocate.

Anyway, back into theorising...

I think I get what you are trying to say.

Are you saying that I'd potentially make more money from doing this sort of thing in a stock that had higher volume but lower spread, ie rather than a 7% spread and only 10,000 shares being traded, I'd be better off with 100,000 shares being traded daily and a 2% spread?

Not on any given day you can't but over time surely averages could be formed.

My idea DEPENDS on people being willing to buy at market

Yes.

I don't really understand what you mean by making money from running stops.

I'm talking about marketing a market for an illiquid share.

What do you mean "go out of business" I wouldn't be "in business" I'd just put a couple of limit orders on the stock in the morning then I'd go about my day job.

I know, but I figured with a wide spread you could make money by being a seller when when buyers are looking for sellers, and a buyer when sellers are looking for buyers. Figured it was all about offering the supply when there was demand.

It was all about the fact that the stock is illiquid so if people need to sell on that day and I'm their best option then they inevitably are going to have to accept the terms that I give which will obviously be on the high side of the market price when selling and on the low side when buying.

ie it's taking advantage of the very same principle as to why you think illiquid stocks are bad - ie you can't get good terms when you need to sell.

Once again this all depends on their being a reasonable spread, ie at least 3 or 4% to justify the brokerage cost and risk.

Does that make any sense?

Of course I could totally be wrong about this company's future earnings, in which case I will be in trouble and I will need to sell, but if my fundamental analysis of the company is poor, that still shouldn't have any affect on playing the spread.

I appreciate that. And I'm not saying this company can't go bankrupt, I'm just saying it's my strong belief that that is unlikely.

I've read the last 10 years worth of annual reports of this company, it's business model is very simple, it's performance has been pretty consistent, and it doesn't have any debt, my valuation of this company isn't based on hope. To be honest if this company even underperforms on my expectations I'm confident the market will see that it is worth at least $0.75 over time.

It's already up 15% from when I started buying it earlier in the year, while the rest of the market has been down 15%. That's got to be a positive sign. And like I said, I have no problem holding stock in this company.

Clearly that must have been done with leverage. I'm not going to be leveraging myself into this position.

And my strategy isn't one of averaging down, I'm just saying that is what would happen if the price fell, which I wouldn't lose any sleep over.

Like I said, I'm going to be buying more of this company over time anyway, so I may as well have it so it's being sold to me at my buying price rather than me having to pay the sellers price.

This idea is an original, which is probably a good indication that it's a bad idea...



Like I said, I just saw a large spread between the bid and the ask today, and I thought to myself "how can I capitalise on this" and my mind got a thinking.

But isn't the great thing about this idea, I'd constantly be selling at a small profit (the top of the spread) and then looking to buy back in when people are selling (at the bottom of the spread).

One day it will be, but like I said, my price expectation at this stage is that fair value is $1.25 and I wouldn't actually consider selling unless it became overvalued.

Well then, it looks like I was on the right track.

 

Everything is fine but...

Sound quite impressive but how about your average return in the last decade? Me? I never get a proper mental framework even I work on it for years.

Human tends to do the things in the similar way. If you could not make fortunes in the past, could you change your mental frameworks in months or a few years? What stopped you to get fortunes in last decade?

Self-challenge is different from self-support and the results can be different. If we lost for a decade while we never try to stop self-support, could we win in next decade.

***
Is it insane you repeat what you tend to do with the expect for different results? 95% or 80% of traders are losers, right?

Are you one of these losers? It is the first test for anyone answer it honestly for himself. Do you dare to answer it honestly?

Feel upset? Yes? You need more efforts to get into the right track!

***
You know, sir, human beings, we got to give them a break in their ways.

We're all mixed bags, don't we?

Something might let us know it very well but few can take the chances.

***
If we don't know it we are not in the right track even we feel so or read for feeling to be so.

Do you know reading can be a self-destructive business under some conditions? You could be not wise but arrogant.

Are you arrogant to the stock market or Mr market? It is a fatal virus in the stock market!

***
By the way, it seems the policy makers hit out proactively in case the Greece crowd would drag all of the world into water. It is a good news even we prepare for the worst event.

Don't forget EU/Greece is not a event but a process. Don't forget enough is enough if you never feel enough in the stock market with plenty of experiences to lose in the last decade. We all are similar at very beginning when we put our toes in it.

Just watch "The wall street, the money never sleep." I seems get a lot this time. All of us have gens to be insane. It is a warning matter if you believe anything too much. It is not just about number but your view about yourself and the world let alone the market.

 

Ahhh......
I think I misunderstood what you are trying to do. I thought that you are talking about different markets.
But in case of shares only, there is no market makers. Only buyers and sellers (unless you are talking about different instruments like CFDs - that is what I understood from your open post).
Now...I am not sure where in this equation you are willing to fit yourself as a market maker??
Problem with illiquid shares is that there are not many buyers and sellers, so most of the time illiquid shares are doing nothing.
Also if you want sell it, you may not find a buyer for a long time.

Running stops is a kind of dirty game (not with shares).
Dealer can see where majority of stop loses are (Fx market), so to make a quick money, he is "lifting" price to that level.
This can be seen on chart as sudden spike, and few sec. later price is back again to previous level.

In case of company records etc...you should read Enron saga and how they played with reports, numbers etc...
Amazing story.

Leverage magnifies gain/loss, but even playing with your own money you can go broke.
Taking small profit is not going to make you rich, if you consider brokerage, tax etc...(brokerage in OZ is a rip off IMHO).
If you check market depth, you'll see that difference between buy/sell is not big (from 1c to few cents, depends what stock we are talking about).
Stockbrokers are always winners, so why don't you become a stockbroker??
No hustle, no pain...