The Secrets of Market Making & Liquidity: Strategies Every Trader Must Know

For every sell order, there is a buyer. And, for every buyer, there is a seller. Do you know who keeps a typical order book ticking? The credit goes to certain financial entities known as “market makers,” which provide liquidity to the market and ensure there are always buyers and sellers available. In this article, we will study the concept of market makers, their various responsibilities, and how they prevent sudden price swings. We’ll also understand how market makers manage risks during times of high volatility, such as market crashes, by continuing to trade when others usually pull back.

Next, we will explain the concept of liquidity and its importance in trading. We will see how it affects our ability to buy and sell assets without significant price changes. The article also covers how external factors like major news or economic events can impact liquidity and influence market conditions.

Lastly, we’ll discover tools like Depth of Market (DOM) and how they help you measure liquidity and analyze market sentiment.  We will also introduce advanced trading tools like Bookmap’s Tradermap Lite, which can help improve trading decisions by filtering out non-executable orders and focusing on real market activity. Let’s get started.

The Role of Market Makers in Financial Markets 

In financial markets, market makers are financial entities that facilitate trading by continuously offering to buy (bid) and sell (ask) securities. Their primary role is to provide liquidity and ensure that there is always a counterparty for traders looking to buy or sell assets. This helps in reducing the bid-ask spread, making trading more cost-effective for all market participants.

How do Market Makers Provide Liquidity?

Market makers provide liquidity by continuously placing buy and sell orders in the market. By doing so, they ensure that securities can be traded smoothly without significant delays. By providing liquidity, market makers also stabilize prices in the market. This is particularly important in markets that are less liquid, where the absence of buyers or sellers can lead to significant price fluctuations. The consistent presence of market makers prevents such volatility by keeping the market balanced. 

Now, see the graphic below to check the various functions and responsibilities of market makers:

How Do Market Makers Manage High Volatility?

During times of high market volatility, like a market crash or sudden economic shock, market makers play a crucial role by continuing to buy and sell securities. When other traders might be too cautious or unwilling to trade due to uncertainty, market makers step in to ensure there is still enough trading activity. This helps maintain market stability by providing liquidity and also prevents the market from seizing up or becoming too erratic.

For example, during the 2008 financial crisis, market makers prevented total market freezes by continuing to buy and sell assets, even when the markets were highly volatile.

Liquidity and Its Impact on Trading 

Liquidity refers to the ease with which an asset can be bought or sold in the market without significantly affecting its price. It is worth mentioning that high liquidity is crucial for market stability, as it ensures that trades can be executed quickly and efficiently. This reduces the chances of drastic price changes which increases investor confidence.

Also, high liquidity leads to tighter bid-ask spreads. This implies that it keeps the difference between the buying and selling prices minimal. Such tight bid-ask spreads:

• Reduce trading costs 

and

• Allow for quicker execution of trades

This happens as there are always enough buyers and sellers in the market.

What Affects Liquidity?

Liquidity is influenced by several factors, such as:

• Market volume (the number of shares traded)
• The number of participants (traders and investors)
• External economic events

Generally, high trading volume and a large number of participants enhance liquidity, while economic uncertainty or major geopolitical events reduce it. For a greater understanding, let’s study the impact of major news and earnings reports on liquidity:

Firstly, understand that positive news increases trading activity and liquidity, while negative news causes participants to withdraw, which leads to reduced liquidity and wider spreads. 

Now, let’s consider the U.S. stock market as an example. Suppose a major tech company is about to release its quarterly earnings report. 

• If the report reveals better-than-expected profits, it could lead to a surge in buying activity.
• This happens as investors rush to purchase shares, which increases market liquidity. 
• On the other hand, if the earnings report shows disappointing results, investors quickly sell off shares or avoid trading altogether, which leads to reduced liquidity.
• Consequently, this reduction causes wider spreads (the difference between the bid and ask prices), which makes it more expensive to trade.

How to Measure Liquidity?

Depth of Market (DOM) is a tool used to measure liquidity. It shows the volume of buy and sell orders at different price levels. By analyzing DOM, traders get information related to market sentiment and the expected price movement. Below is a simple specimen of a DOM as it might be seen on any trading platform:

Where,

• Price ($): The different price levels at which buy and sell orders are placed.
• Buy Orders (Volume): The quantity of shares or contracts that traders want to buy at each price level.
• Sell Orders (Volume): The quantity of shares or contracts that traders want to sell at each price level.
• Best Bid: The highest price at which someone is willing to buy.
• Best Ask: The lowest price at which someone is willing to sell.

Also, in this specimen, the best bid is $50.00 with a volume of 3000 units, and the best ask is also $50.00 with a volume of 3000 units. Traders can use this DOM to determine the optimal prices to place their orders or predict short-term price movements based on buy-sell order imbalances. For more clarity, let’s study an example and learn how to use DOM to gauge market sentiment:

Say on a trading day, you witness the following order book:

Now, we can observe the following from the above order book:

• • Large Buy Orders at $50.02
    • There are 5000 units (shares, contracts, etc.) that buyers want to purchase at $50.02.
    • This high volume of buy orders indicates that many traders believe $50.02 is a good price to buy.
    • This suggests strong demand at this price level. 
    • If the current price is below $50.02, this large buy volume could push the price up toward $50.02, as there are many buyers eager to purchase at that price.

• Sell Orders at Different Levels

• • At $50.05, there are only 300 units available for sale.
  • This indicates that there is less supply (fewer sellers) at this price.
  • Also, it means the price might rise until it meets a level with more sell orders.

Hence, while observing the DOM, if you see a large number of buy orders at a specific price level (e.g., 5000 units at $50.02), it indicates strong demand at that price, suggesting the market might move upward. Whereas, if there were a large number of sell orders at a price level (e.g. if there were 5000 sell orders at $50.05), it would indicate strong selling pressure. It usually suggests the price could move downward if sellers start to outnumber buyers. Also, in this case, since $50.02 has a large buy volume, it acts as a support level. 

Strategies Employed by Market Makers 

Market makers play a crucial role in ensuring that financial markets remain liquid and stable. They do this by constantly buying and selling securities, even during times when other traders might be reluctant to participate. Their continuous activity in the market helps to:

• Prevent extreme price fluctuations 

and

• Ensure that traders can execute their orders smoothly.

Let’s understand better through an example related to the market downturn:

Firstly, understand that during a market downturn, when investor confidence is low and selling pressure is high, market makers step in to buy assets that others are selling. This action prevents a free fall in prices and provides the necessary liquidity to keep the market functioning. 

For example,

• Say there’s an economic downturn. 
• Because of the bad news, many traders start selling their stocks.
• This leads to a sudden drop in prices. 
• Normally, this could cause a severe price crash.
• Now, a market maker steps in and places large buy orders at certain price levels.
• Let’s say they place orders to buy:
  • 7,000 shares at $49.90,
  • 5,000 shares at $49.85, and 
  • 6,000 shares at $49.80.

Now, let’s see how the situation unfolds both with and without market makers:

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How Do Market Makers Earn Profit from the Bid-Ask Spread?

Market makers profit from the bid-ask spread, which is the difference between:

• The price at which they are willing to buy a security (bid) 

and 

• The price at which they are willing to sell it (ask)

By setting these prices strategically, they capture the spread as their profit. For instance:

• Imagine a stock that is currently valued at $500.
• Market makers step in and set a bid price of $499.50 and an asking price of $500.50. 
• If a trader sells at $499.50 and another buys at $500.50, the market maker earns $1 per share as the spread, assuming no other costs.

How Do Market Makers Manage Trading Risk?

It is worth mentioning that market makers are exposed to various risks, which commonly include:

• Price volatility 

and

• Adverse market movements

To manage these risks, they employ strategies such as hedging. Following this, they take opposite positions in related securities to offset potential losses. Also, they prefer diversification, where they spread their investments across multiple assets to reduce the impact of any single adverse event. For a greater understanding, let’s study two hypothetical examples:

Example I: Hedging with a Derivative:

• A market maker holds 10,000 shares of a volatile tech stock, currently priced at $50 per share.
• They are concerned about the possibility of a significant price drop due to market volatility.
• Now, to protect against a potential price drop, the market maker buys and puts options on the tech stock. 
• Each option contract covers 100 shares
• The strike price of the put options is $48. 
• They purchase 100 put option contracts
• Let’s assume each put option costs $2 per share. 
• So, the total cost is $20,000 (100 contracts x 100 shares per contract x $2) 
• Now, say the stock drops to $45. 
• In this case, the value of the put options will rise.
• This allows the market maker to sell the options at a higher price and mitigate the losses from the stock.

Example II: Diversification

Instead of holding only the volatile tech stock, the market maker diversifies their portfolio by also investing in other sectors. Check their portfolio composition below:

Now, let’s say the tech sector is experiencing a downturn. The tech stocks drop by 10% and their value falls to $450,000. However, if the healthcare and energy sectors perform well, and their stocks increase by 5%, their values rise to $420,000 and $504,000, respectively.

In this case, the new portfolio value will be: 450,000 (Tech) + 420,000 (Healthcare) + 504,000 (Energy) = $1,374,000.

Hence, the overall portfolio only decreases slightly to $1,374,000, despite the tech stock’s decline. This reduction is less severe than if the market maker had only invested in the tech stock.

Identifying Market Maker Activity and Analyzing Liquidity 

It must be noted that advanced trading tools are essential for:

• Identifying market maker activity 

and

• Analyzing liquidity

See the graphic below to learn about these tools:

By using these tools traders can understand where market makers are placing their bids and ask. This information helps to identify the:

• Liquidity positions 

and

• Potential market trends.

How Algorithmic Trading Bots Influence Liquidity

Algorithmic trading bots, including market maker bots, have a significant impact on liquidity and market behavior. These bots execute trades at high speeds based on predefined algorithms. They continuously adjust bid and ask prices to provide liquidity. In this way, these bots contribute to tighter spreads and more efficient markets. This happens because they can react instantly to changes in market conditions, which ensures continuous trading activity.

Human Market Makers vs. Algorithmic Trading Bots

One must be aware that human market makers and algorithmic trading bots differ in their approach and impact on liquidity. Let’s see how:

How Bookmap Can Help?

Bookmap is a modern market analysis tool. It offers Tradermap Pro, an advanced add-on that allows traders to create specialized heatmaps for financial instruments by applying various filters to the order book. 

One of its key features is the “Bot Remover filter.” This feature allows traders to filter out non-executable orders created by market maker bots. For the unaware, these are orders placed too high or too low compared to the current market price. For example, if the current price of a stock is $50, a bot might place a sell order at $55 or a buy order at $45. These orders are unlikely to be executed because they are far from the current trading range.

By filtering out such orders, traders can see a clearer picture of the real, executable orders that are close to the current market price. This helps them make better trading decisions without being distracted by the irrelevant orders placed by bots. Enhance your trading strategies with Bookmap’s advanced tools. Sign up today!

Conclusion 

“Market making” is the process of providing liquidity to financial markets. Done by market makers, it ensures smooth trading and stabilized prices, especially during times of market volatility. These market makers continuously offer to buy and sell securities, which makes it easier for traders to execute their trades quickly and at lower costs. By doing so, they help prevent extreme price fluctuations and keep the market functioning efficiently.

It is significant to note that “liquidity,” or the ease of buying and selling assets without affecting their prices, is crucial for market stability. That’s because high liquidity leads to tighter bid-ask spreads, reduces trading costs, and makes the market more attractive to participants. Investors and traders must understand that trading volume, the number of participants, and economic events impact liquidity, with positive news boosting it and negative news often reducing it.

To gain a competitive advantage, traders can also prefer using tools like Bookmap’s Tradermap Lite. It provides deep insights into market maker activity and liquidity. By offering features like the “Bot Remover filter,” helps traders focus on real, executable orders by filtering out non-executable ones created by bots. In this way, traders get a clearer view of the market. Optimize your trading with Bookmap’s Tradermap Lite. Get started here!