Almost everything you have ever been told about
world's stock markets is probably wrong. Almost everything you have ever assumed about world's stock markets is also probably wrong. You probably believe that share prices go up and down due to classic 'supply and demand' laws. You probably believe that over time, world's stock markets will go up because of increased economic production, or inflationary pressures. You probably believe that your broker, though undoubtedly a parasite, makes his money reasonably fairly by charging you an honest declared spread between his bid and offer price. You might even be laboring under delusion that 'fundamentals' or 'interest rates' drive price. Wrong, wrong, wrong and wrong.
So where's proof, I hear you cry. OK, here we go.
Markets are composed of players of all sizes (including you and me!) according to www.traders101.com, largest of whom are 'Market Makers'; firms who have an obligation to quote a price on particular securities whatever overall market is doing. Brave of them, I hear you think - imagine having to buy Enron as it plummeted. Surely they ended up with most of that worthless stock in their own portfolios? Er, no. So where did it go then? Patience, little investor.
Get something straight in your mind now - although these market makers would like you to think that they are simple 'middle men', buying from Fred and selling to Joe, while pocketing spread between those two prices in an honest, upfront sort of way, truth is rather more devious (not to mention complicated). The real tool that market makers use to create their own profits is embedded within that sentence. The spread. I hear you think, "I have no problem with them charging a fee for their service - everyone has to make a living, and it's only a few percent after all! ". Wrong again! The whole concept of a 'spread' allows a market maker to control market in same way that a shepherd controls a flock of witless sheep. Let me elaborate
How Market should work Imagine that a market really IS controlled by laws of "supply and demand", and rises and falls due to imbalance between external buyers and sellers (you and me) competing for, or shunning certain securities. In this wonderful la-la land, market makers really don't care what market does, as they make their own money from spread. And a nice profit is is too. But hang on - isn't there any way to make MORE money from these investing sheep? Of course there is.
How Market really works To lubricate their transactions, market makers need a supply, or inventory of securities they support. This can either be real certificates, or via a process called 'stock lending' (don't worry about THAT one yet - it basically means they borrow stock or "pretend" they have it). Once you have an inventory of stock, and concept of 'spread' (or 'edge'), a marvelous opportunity opens up. The average price at which a market maker accumulates a security and average price at which he distributes it are going to be different. Add this to fact that market maker sets price tick by tick, and boom! A license to print money. Observe closely, this is a good trick.
Let's play Chicken I, as a market maker, decide (for no real reason, or perhaps because there has been some trivial news about them) that stock in ABC Corp is my plaything today. I don't have much of an inventory in that particular security, so what do I do? Mark up price so external holders will sell me some? No. I mark price DOWN. Oof. Some external parties see this as a buying opportunity, and as I am a market maker, I am obliged to sell them security at new, lower price, meaning I am even shorter on that security.
