How a Broker Can Avoid a Market-Maker's Tricks

The Nasdaq is more efficient than the other major stock exchanges because it uses lightning-fast computer linkages, which are typically open outcry floor models. But the process used for executing Nasdaq trades is far from perfect. The Nasdaq is also known for giving market makers, who make their living trading Nasdaq stocks, ways to fool brokers and investors into thinking that they are getting the best price when they are not.

Here are the tricks and gimmicks some market makers use.

Trick #1: Giving Phony Sizes

When a trade is called into the floor of the New York Stock Exchange (NYSE), it is immediately routed to a specialist in the stock, who may have limited interest in the individual trade.

The specialist is inundated by traders and simply wants to find a buyer or a seller for that trade as fast as possible. Essentially, the specialist is an intermediary who sometimes takes positions in stock but is really there to function as a provider of liquidity.

By contrast, Nasdaq market makers routinely take positions in stocks, long and short, and then turn them around for a profit or a loss later in the day. They provide liquidity, too, but they are more focused on capitalizing on your lot of stock by buying it for their own trading accounts and then flipping it to another buyer.

In any case, market makers will sometimes post phony sizes in order to lure you into buying or selling a stock.

For example, market makers may post a bid and an offer that looks something like this:

 $\$10-\$10.25 (75 \times 10)$$10−$10.25(75×10)

This means that they will buy 7,500 (multiply 75x100) shares of your stock at $10 per share and they will sell 1,000 shares of stock at $10.25.

They are obligated under Nasdaq rules to honor those sizes. However, the market maker may own a position in the stock. Posting a bid for 7,500 shares is an attempt to fool brokers and investors into thinking that there is a big demand for the stock and that it is moving higher.

This kind of activity is frowned upon by the Financial Industry Regulation Authority (FINRA), but it is still fairly common in practice.

If someone tries to sell 7,500 shares to the market maker, the purchase must be accepted because the bid has been posted.

How It Works

So what happens? Most brokers will pay $10.25 for the stock just to get the trade done. But in reality, the purpose of posting a big bid was to sell the market maker's 1,000 shares at $10.25. The trick worked!

Incidentally, the same trick can be used in reverse on the sell side of the equation. The market maker may show a big offer of, say, 10,000 shares. Brokers see this and think that the market maker is looking to unload a big block of stock. They quickly sell their shares at the bid price (which, using the above example, is $10).

In this case, the trick works again because the market maker fools the broker into selling the shares at $10, precisely the price the market maker wanted.

How to Avoid This Trick: Watch a stock trade before buying or selling it. Learn the players in the stock. By watching the action on a level 2 or level 3 screen, you can tell who is accumulating shares or unloading them. That will give you a better idea of whether the sizes the market maker posts are real.

Trick #2: The Ticket Switch

To enter an order, a broker usually fills out an order ticket and gives it to a clerk. The clerk, in theory, executes the order or gives it to a trader. In doing so, the clerk takes the broker's ticket, timestamps it, and attempts to execute the trade.

The market is moving while this process is going on. A stock could move from $10 to $10.12 to $10.25 in the time it takes a broker to hand the ticket to the clerk.

How It Works

Some clerks will take the ticket, note that the stock moving higher, and buy it for $10.12 for his or her personal account, and then turn around and sell it at $10.25 to the broker who originated the order.

What happens if the stock goes down to $9.75 immediately after the clerk buys it? It's illegal, but the clerk could take the physical ticket, switch the account number on the bottom, and tell the original broker the stock was purchased for $10.12.

Incidentally, market makers will pull this same trick, buying and selling the stock for their own accounts and using your trade as a cover.

How to Avoid This Trick: Brokers should watch their order entry clerks place the order and wait near the order window to see if they "got a fill." If the transaction is done electronically, correspond immediately with a trusted order clerk or the market maker, or both, to see your execution price. Also watch how the stock moves to make sure that nobody is making money off your trade.

Trick #3: Jumping Ahead of Market Orders

A broker who places a market order for a stock is giving instructions to buy the shares at whatever the current price is. This can be a lucrative order for an unscrupulous market maker.

Using the same example as before, suppose the quote as posted looks like this:

 $\$10-\$10.25 (75 \times 10)$$10−$10.25(75×10)

The market maker who is getting hit with orders may sell 1,000 shares at $10.25, then 500 at $10.30, and so on. But if your market order lands in a basket of orders to be filled, you are giving the market maker carte blanche.

In other words, you are willing to pay any price to get into the stock. And you will.

In most cases, a market maker will make sure that you get filled at a high price and you won't even know it happened.

How It Works

Here's how it works: You watched the stock moving higher and assumed you were just last in line. In reality, the market maker saw your order in a long line of orders and simply bumped up the offer price to take advantage of your carte blanche.

Working for you are the time-and-date stamps on the physical tickets. This running electronic tally of bids and offers helps limit such occurrences. And, these actions are monitored internally at the firm and might be spot-checked by regulators. Despite these safeguards, it's hard to prevent or to prove this trick in a stock that experiences high volume.

How to Avoid This Trick: Don't place market orders. Use limit orders. In the example above, your order should sound something like this: "Buy 1,000 shares of XYZ stock at $10.25 or better for the day." This means that the maximum amount you will pay is $10.25, and the order is good only for this trading day. It gives the market maker fewer opportunities to manipulate you and your client. Of course, it also means you might miss out on the order should the price rise above your limit.

After all, market makers are trying to make money. That's their job. Your job is to keep an eye on your order immediately after the trade is placed. In the long run, both you and your clients will be happy you did.