Markets Makers - to use or not to use?


Q.: So are there different types of CFD providers?

A: Yes, there are two main types of cfd brokers, those that simply take the role of agents, hedging all CFD orders in the underlying exchange (this arrangement is also known as giving investors direct market access), and those who make markets in contracts for differences, living off their own spreads. There are also hybrids of the two as well but an investor is likely to get the best execution through the first 'agent' type of intermediary. There are however many other considerations - for instance if you buy shares and hold them only for a very short-time period then having direct market access will be crucial, on the other hand if you are likely to hold a position for days or weeks, then using a market maker platform won't really affect your trading (in fact it may be beneficial as market makers.

Other considerations to take into account are depth of research coverage and technical analysis. The technical capabilities of the trading platform are very important, especially for frequent traders. The credit rating of the provider is also an issue.

 

Q.: What is direct market access and how does trading inside the spread works?

A: Trading inside the spread can be best explained by an example -:

1. Ask 19.25
2. Bid 19.00

If you deal through a broker you will at best be offered 19.2 to buy and perhaps 19.05 to sell. The only exception to this is if the market maker (who has Level 2 access) sees an imminent price movement. Then you may get offered a better price for a minute or so.

When you have direct market access, YOU decide on your price to buy and sell.

The problem with trading via a broker is that even though you may put in an order, this order won't go through to the order book. It sits on the broker's server until it knows that the price has changed.

With Direct Market Access you can make an order for buying at 19.00 and selling at 19.25. This is then placed on SETS ready for a sudden swing. You get to control the action whilst all the others just get to watch.

Throughout the day, the more volatile and liquid stocks will have sudden price jumps when a big player decides to buy all the available stock that's sitting on the order book at a certain price. By the time the price has moved on the ordinary feed your brokers order will have missed the action.

This is what is meant by trading inside. All the others trade outside the spread. Once you have mastered it you will realize just how easy it was not to make any money doing it the old way.

There is also another fundamental difference in trading by direct access. When you watch the shares that have been traded you will see AT against quite a few trades. This is Automatic Trade. It means that the order book has matched two traders that both want to buy and sell at the same price. Both get their price with no market maker getting his cut. Another big plus and another example of trading inside the spread.

If you're starting out in direct access the first thing you should do is to get Level 2 feed trial and watch the price movements. You can then paper trade and see what goes on.

Note: Where Level 2 has helped me in the last months is that it sometimes tells me whether the price change is going to be held up until a seller is out of the way . Level 2 information is however less useful for very liquid stocks like those in the FTSE 100. However, when dealing using Direct Market Access (DMA), Level 2 can still come in useful to some extent because you can place your order where you want it. I got out of RMM (LON) stock today just before it went down. Level 2 allowed me to do that because I could see the Market Makers moving down rapidly. When there was one only one Market Maker left on the Bid it was sell or get caught as the last market maker moved down. It only went down .25p but that .25p is in my pocket, which is just the way I like it. Keep an eye on it to see how this works...it's currently 2 x1, that is to say 2 Market Makers on bid and 1 on offer. For the price to go up, the 1 market maker has to put is price up, for it to go down 2 market makers have to lower their price.

Q.: What is the difference between the direct market access model and the market maker one?

A: Ok, as we have mentioned above there are some CFD suppliers who do so on a 'Direct Market Access' basis - that is their bids and offers EXACTLY match the bids and offers in the actual market they are supplying the CFD for. Other CFD suppliers do so on a 'Market Maker' basis - that is the supplier decides EXACTLY where the bid and offer is. The Market Maker also decides WHEN (and IF) you will be allowed to trade. You may hit the 'BUY' button on your computer, but the MM will decide exactly when your order gets done, if the MM wants to delay the execution of your order, it will. When you sign the agreement with the CFD supplier (the MM) you agree to allow the MM to do these sorts of things with your orders. Note also that a market maker can only execute the full order or none of it, partial fills are not possible unlike DMA, so you may experience re-quotes when dealing.

I think an analogy (a dodgy one, very imperfect) might be found in comparing a fruit and vegetable market with, say, Coles. If you want to buy some grapes you can go to a fruit and veg market (say Paddy's in Sydney, the Queen Vic. in Melbourne, for examples), compare prices and deal with any of the sellers of grapes. Alternatively, you can go to Coles - but Coles will set the price of the grapes and if you don't want to deal at that price then no grapes for you. You could try Woolworths and see what their price is, though (i.e. use two CFD suppliers - but the 'grapes' you buy from one CFD supplier are NOT the same as from another CFD supplier, so you couldn't buy a CFD from CFD Market Maker Supplier "A" and sell that CFD to CFD Market Maker Supplier "B").

Choosing whether to deal with a market maker or DMA broker really depends on which products you intend to trade and your trading timeframe; the shorter your timeframe for trading the more you will need to rely on a DMA CFD provider, however if you want access to the world's markets from one account then a market maker might be more suitable. Most professional traders opt to use both.

Q.: Given the advantages of DMA over a quote-driven platform why would anyone want to use a quote-driven broker?

A: Market Made CFDs do have some advantages over DMA CFDs in that they are usually available over a much wider choice of stocks and indices. In fact, one of the main benefits of using a Market Maker CFD broker is that they can offer pretty much any market you want from anywhere in the world; all this from one single account and trading platform. As many of the CFD providers are just market makers they can adjust the tick value on instruments such as S&P, Dow, Oil and Copper to make them more tradable for small accounts as well instead of trading the full futures contracts or minis.

In reality, both DMA (Direct Market Access) and a quote-driven service (also referred to as a synthetic market) have unique advantages. It is usually easier to setup a quote-driven account and no minimum trades are required, either in terms of $$$'s or minimum number of trades. When trading a derivative some prefer having the synthetic market provided by a quote driven service like GFT rather than the DMA by IG.

In a synthetic market like that provided by GFT UK you can set a guaranteed stop loss while in a DMA platform you can't. This is an important difference especially when trading CFDs when your positions are leveraged. Of course, DMA is great when things are going well but when things go badly it can really blow out due to lack of buyer liquidity.

Market Makers are also able to offer additional liquidity in bigger shares, the reason for this is because they have positions on their internal order book which they would like to clear out. Also, a quote-driven service does not limit you by the order flow as in a DMA platform. If there are only 10 shares available at the price you want on a DMA platform you can only buy 10 shares. On a synthetic model like GFT Global Markets UK you could buy 100,000 shares, and because its a 'made up' (but which still roughly follows the market price) if I wanted to sell 100,000 shares I could sell them instantly. No waiting until your sell order is filled by sufficient other people wanting to buy 100,000 shares to get out.

To summarise, one of the biggest advantages of the OTC structured products market is that it allows providers to tailor-make their product offerings to the individual needs of retail clients, taking into account risk appetite and suitability. But of course, the OTC nature of CFDs can also be a negative trait as you have to sell through whichever provider you dealt in the first place and price transparency may be unclear as they are not exchange traded instruments (not an order driven market but a quote driven market).

Q.: Is it a good idea to steer clear of market makers?

A: If you are referring to over-the-counter CFDs in the form of the market maker model then the majority opinion is that it is better to use DMA models rather than Market Maker models.

Direct Market Access is very much like trading the real market, i.e. you have access to the same market depth, same spreads, and can even participate in opening and closing auctions...etc. Client orders are hedged by the CFD provider matching real orders in the exchange, so the CFD provider is not affected by movements in your positions. Thus, the CFD provider doesn't lose money if you win, since they have actually placed an equal position in the real market. Their equal position offsets any gain or loss they would otherwise sustain if they were taking the opposite side of your position like a market maker might.

Market Maker CFDs on the other hand can have different bid and ask prices, and wider spreads. Market Makers can basically quote you any prices they feel like, which means that certain products may have a larger than normal spread. Occasionally, and especially when trading in large size or fast markets, the original order may be refused and the system then comes back with a less favourable quote. So for an illiquid market such as SoyBeans or Silver, your provider might in certain situations increase the bid-offer spread as the market maker won't want to put himself at risk. And a market maker doesn't have to place each trade in the real market, so there might be situations where the broker might be trading against you. This is because market makers may or may not hedge, partly or fully, whether they are matching internal liquidity or not. They will only pass volume onto the market if they can't balance the order in their book

Unhedged Example (Market Maker):

The contracts for difference contract is between you and the CFD provider no other party is involved. If you gain $5,000 on your long position, where do you think that $5,000 is going to come from? It comes out of the CFD provider's own funds, right? Therefore, can you see that they are effectively short when you are long, even though no short position was taken out? The further the stock rises, the more money the CFD provider loses, to you. It's like you are making a bet with the CFD provider. If you win, they lose. If you lose, they win.

Hedged Example (DMA):

Now consider how the CFD provider might hedge against the above example. Would they open a short position? NO! If they opened a short position, they'd still lose the $5,000 that they owe you, PLUS they'd also lose another $5,000 on their short position. To hedge against the above example, they'd have to go LONG (the same as you). If you gain $5,000, they use their $5,000 gain on their long position in the real market to offset the $5,000 that they need to pay you.

Market Makers Balancing Mechanism

Market Maker has an order book which they balance internally. i.e. if you place long on X they try and match it against a short on X from another of their clients, thus making money from the spread. They will only go to the market to hedge ANY position when their order book is unbalanced (e.g. if you went long 10 positions of X and their other client was only short 9 positions of X they would take to the market to find one more short to balance). So the market maker can "win" on a position you lose on by rebalancing it against the next sucker, NOT by simply being the counterparty to your trade. Thus, they will only pass volume onto the market if they can't balance the order in their book. The main problem with this model is lack of transparency from the client perspective as they don't see the full picture.

Forex and Index Trading

I do use a Market Maker for part of my trades and have adapted the way I use the CFDs to avoid the pitfalls associated with Market Makers. Note, however, that you can only trade indices and foreign exchange using a market maker.


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