How do market makers adjust prices?
September 16, 2008
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John Forman - The Essentials of Trading author
Here’s a question which came in over the weekend from Wally about market makers:
Here’s one: how exactly the prices are adjusted by market makers (MMs)? Electronically nowadays, I presume? Is there an algorithm for changing bid and ask depending on incoming orders or can MMs just move the price in their favor even before a big order arrives?
For example, there is light trading between bid and ask (100 - 200 shares) with advertized sizes around 100 (10000 shares). It appears that MMs can drop the bid even before a large sell order becomes visible.
I’d be interested in books or any other information dealing with the actual mechanics of price movement.
This is definitely one of the most directed and specific questions I think I’ve ever seen, and certainly out of the line of common questions. 
Not being a market maker myself, I can’t address this question with any real authority. I’ll try to see if I can get someone with that type of experience to contribute their input by way of a comment. In the meantime, I’ll offer up a few thoughts of my own from what I have seen over the years.
The main point I would make is that you have to realize MMs are in the business of looking to generate maximum transaction flow. The more times they are able to sell at the offer and buy at the bid the more money they will make. That means they are going to adjust their bids and asks to the levels where they thing they’ll be able to do the most trades, generally speaking.
Naturally, there are going to be situations where other considerations come into play. This includes changes or anticipated changes in volatility, directional anticipations, and any position balance the MM might already have. I’m sure there are MMs who use algos, but I’m also sure there are others who operate less mathematically, or in some combination.
I encourage any reader with experience or knowledge of MM to post a comment with your insights.
Here are some other posts which might interest you:
This is a very specific question with not very specific answers. I was a market maker for a major Wall Street firm for over 7 years. Most of the time market maker quotes are updated automaticlly by an internal computer system with parameters set by the market makers on a stock by stock basis. For instance if i buy stock on the bid, the sytem will automatically move my big quote down by .25 as well as my offer. In volatile situations, these automatic settings are taken off, and market makers move there quotes manually. I might want to move by .50 or 1.00 of a stock is really volatile. Hope this helps
That’s great Nick. Thanks for adding your experience to the discussion.
From Wally in response:
John, I both appreciated and was impressed by your prompt reply.
The first, because I expected platitudes and generalities instead of a straight answer. The latter, because you said that you didn’t really know. In my book it’s a sign of a great mind - to publicly acknowledge ignorance. After all, who knows everything?
I’m not sure that “working the spread” is the main source of profit for MMs. Spreads nowadays are mostly 1c and the competition is brutal. Since MMs are allowed to trade for themselves (including naked shorting!) it’s easier and more profitable for them to initiate or exaggerate swings of 10-30c. Even if I’m too cynical, their experience, superior tools and no need to pay commissions+spread — all give them the edge aside from manipulation. I would be king if I didn’t have to pay 3c commission on a roundtrip and could buy at the bid!
Thank you,
Wally
Wally - You’re right that competition is fierce and spreads narrow, but at the same time volumes generally rise over time so there’s plenty of money to be had in the market making game. The creation of all the new forex brokers/dealers is a perfect example of that.
As for it being easier and more profitable to play those larger swings - do you really think so? There are an awful lot of people out there trying to do just that and most of them aren’t succeeding.