March 6, 2020

How Does a Market Maker See the Market?

How Does a Market Maker See the Market?

In this article, we would like to discuss the problem of “secrecy” of the Forex market and get the message across to some traders who cannot understand it.

How does the Forex market differ from other stock exchanges, for example, the New York Stock Exchange (NYSE)?

The difference is that the latter has a certain central server where all orders are processed and the process of pricing itself takes place.

Traders have access to such exchange information as the volumes and the number of trades and also data on all pending orders. In other words, everything that happens in the stock market is displayed in the terminal of a trader.

In turn, Forex is a decentralized market which means that any exchange information is simply missing there. Therefore, most traders trade in the market almost blindly, relying only on indicative prices.

You will agree that there is a difference – analyze only with the help of technical analysis or use it as well as trading volumes, order book, delta, market profile, and other exchange tools. By the way, maybe it is for this reason that the percentage of profitable traders in the securities market is greater than that in the Forex market.

Consider an illustrative example: Forex can be compared with a puppet theater where they show us a beautiful show program, and everything that happens behind the scenes is hidden from our eyes. We don't know what's going to happen next and who's running the dolls. Perhaps, it’s a friendly gentleman, or maybe it’s a wily mister.

Who is a Market Maker?

Simply put, a market maker is a market participant that has influence in pricing. As we understand it, a market maker is any market participant able to influence the price of a particular financial instrument.

Just to be clear, now we are not talking about some mythical man who trades in spite of them all, but about specific players in the Forex market: banks, funds, as well as large private investors.

In addition to the ability to influence the price, market maker has other benefits as well. Market makers do have some information about location of Limit and Stop orders of small market participants (it’s about us). We don’t know exactly where this information comes from – maybe you’ll give us this idea. In case of large banks, we can assume that they analyze an aggregate trading activity of their customers and possibly pass these data on to other banks, but we will never know about it.

It may seem that market maker is almighty, but the fact is that most of them cannot simply reverse the price at any time; besides, there are other market makers which can prevent it from doing so.

What Do Traders See, and How Do Market Makers See It?

Let's consider an ordinary trader and look at what he/she sees (uses) on own chart every day. So, first things first:

1. Indicators are some formula that uses “past” data and allegedly predicts something, but, unfortunately, they, alas, actually do not predict anything.

2. Lines, channels, supports, etc. In this case, they are effective to a certain degree, but it is impossible to determine exactly whether there is a support at any particular level.

3. Patterns, formations, and waves. Again, one cannot know in advance whether the price is going to interact with this pattern. However, most traders see simple patterns, so some interaction of the price with them can be still seen.

The list goes on, but that's enough for us. Considering all of this, we can conclude that traders analyze the market horizontally. That is, we take some historical data (chart), seek for regularities, draw lines, but with all that, we don’t know what is actually happening there and why the price did not obey our indicator.

In turn, market makers don’t really care what MACD tells us or that the “Butterfly” pattern is fully completed and a possible trading scenario has begun to happen. Moreover, they don’t even look at the chart and don’t need volumes, since all of that is the “past” information.

Market makers analyze the market vertically. They have a so-called order book (just like the one in the picture below), where all our Take Profits, Stop Losses and pending orders are displayed. They simply don’t need any other information as they can influence the price movement.

Here is an illustrative example of how the vertical view differs from the horizontal one:

While the Moving Average indicator signals a buying opportunity on the chart on the left side of the picture above, the cluster of Stop orders below the current price is clearly notable in the order book on the right side of it. It is such clusters that market maker is interested in, and, as we see it, the price responds accordingly.

As we said before, market maker can't simply reverse the price. However, it can push it to the required level, move it towards the cluster of Stop Losses, or help to form a pattern and then make its possible trading scenario happen, if it is in its interests, of course. Put in other words, on the one hand, it acts against the market crowd, and on the other hand, it needs another part of the crowd to push the price in the right direction. We need a picture to illustrate it.

Let’s examine it in more details. Assuming that a market maker wants to buy a currency and, of course, it wants doing it at the best price. The left side of the picture above shows pretty good cluster of Sell orders, which are our Stop Losses as well. This volume of Sell orders will well satisfy the demand of a market maker. On the other hand, we can see a cluster of buyers – they will be used as a safety cushion to prevent the price from going further. Now it’s easy – market maker pushes the price towards the cluster by placing small orders, gather all sellers in one place, and Limit orders acting as a support restrain further price movement.

By the way, we use pictures showing the Oanda order book in our examples, but this is not exactly the order book that market makers have. However, this is a small part of it that is available to ordinary traders and well-suited for the examples provided in this article. If you are unfamiliar with the concept of the order book, read this article.

Short aside: once we posted these pictures on a major online forum (intended for newbie traders) which is also known for its specialization in “Ilans” and other Expert Advisors destroying deposits and pretending to be profitable trading robots. So, all we got in response to our request to share knowledge was a phrase like this:

“It doesn’t make sense to understand what the middle line is and what its readings mean. It's easier to say that “crossovers don't work”. You just need to think a little and recall the high school course of mathematics.”

Of course, it made us smile, but the problem is that there are many more of such “experts” on that large trading forum and a huge number of self-proclaimed traders continue to hide prices under the “layer of indicators”.

It's obvious to us. How about you?

market makers

The first obvious thing is as follows: there is no use fighting with market makers – after all, it is not for nothing that they are called “smart money”, and ordinary traders are called “housewives”. They know better than we do how the price will behave and how to make money on it (surely, they push the price by themselves!).

Unfortunately, we don’t have the precision tools to track market maker, so all we can do is to try imitating its behavior in the market.

What do we need to do it? We need to act against the market crowd since this is their (market makers’) primary strategy, otherwise they would simply not make money.

The second obvious thing is as follows: finally, we should realize that indicators are a dead-end road. The market and, in particular, market makers don’t take them into account, and we’ll try to prove it in our next articles (1, 2, 3). The only useful indicators are the informative ones, for example, round-levels, trading sessions or news indicator.

What to use for the analysis then? Any available exchange information on Forex (volume, ratios, and order book), important price levels, patterns, and trends.

The third obvious thing is as follows: Forex doesn’t tolerate negligence – you must understand what you’re doing and why. Professional trading is a conscious systematic approach, but not a set of rules.

Simply put, if you’re using an indicator, you should necessarily know its formula and understand its readings, but don’t do like that: “RSI has exceeded 70 – I’m willing to sell!” We recommend you to read this article on the given subject.

We hope you have enjoyed this article and been able to learn something new from it.