The Market Maker Gold Mine

Created by EQUITIES Magazine

Bernie Madoff went from being a relatively unknown name with the public to a highly recognized one in just a matter of months—but, of course, for all the wrong reasons.
What most people don’t understand about Madoff is that he made a great deal of his wealth not through his investments but through his market-maker firm. Avid traders knew his company as MADF on their Level II screens.

If you’re not familiar with market makers or their roles, these companies are registered to act as dealers in a stock. They buy, sell, and accumulate shares in a stock on behalf of their clients or for their own accounts. They fill both market and limit orders, and they provide much-needed liquidity to maintain at least some level of stability in the stocks they feature.

Unlike specialists who operate on the floor and deal with NYSE stocks, market makers work out of sight—executing orders by computer or sometimes by phone and work with NASDAQ stocks. Smaller firms may only dabble in a few stocks, while bigger firms may operate in a couple dozen.

So how did Madoff’s firm—as well as other market makers—make so much money?

They do so in four basic ways.

Market makers capture the spread between the bid and the ask price on orders, receive commissions from large institutional clients (such as mutual funds), get order flow from brokers, and trade for their own accounts. Madoff was instrumental in developing the order-flow aspect, in which market makers would pay brokers such as E-Trade Financial Corp. (NASDAQ: ETFC) or The Charles Schwab Corp. (NASDAQ: SCHW) to funnel customer orders to them.

All this adds up to a fortune because of the sheer amount of trades processed each day. And, with the wild volatility and big movements over the past year or so, market makers are really making money.

It’s fascinating to watch market makers at work. You need a Level II screen to do this, and unless you know what to look for, most of the action will escape you. But if you have a deep understanding of what’s going on, you’ll marvel at how adept market makers are at their craft, as well as how many tricks they employ on unsuspecting market participants to create even more profits for their firms.

Trust me, it’s a real eye-opener.

By Fausto Pugliese
Fausto Pugliese is the founder and president of Cyber Trading University, a world leader in online education and training for traders and investors in the markets