How the Stock Market Really Works, Part II

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In my previous article How the Stock Market Really Works, I detailed how the order types and trades are all abstractions around buy and sell offers on the order book, and some philosophy around strategies, valuations and what a stock truly is.

Now I venture into the hidden world of shorting, options, market makers and dark pools for US equities and options markets.

Everything you’ve been told about how the stock market works… that’s not how it works anymore, at least not in the US.

What is a dark pool?

A dark pool is essentially a private stock exchange. It’s been estimated that 40–50% of all trades occur in dark pools. Retail investors don’t have access to dark pools, so you don’t see how many shares are being exchanged or at what price. They sound ominous but their primary benefit is that the dark pools allow for spreads of less than 1 cent, whereas stock exchanges are, by law, not allowed to offer bid or ask prices in fractions of a cent. Institutions that have access to the dark pools can therefore trade between each other at much more narrow prices.

Dark pools also allow institutions to keep massive trades out of view of the public. Previous to dark pools the same institutions would split their gigantic orders into lots of little pieces so as not to scare the market. So it’s not necessarily that anything untoward is happening by use of the dark pools.

What is a market maker?

All the popular online stock brokers offering commission-free trades route the trades exclusively to market makers, as do some of the commission-taking brokers. Hence most trades performed by regular investing folk, for both stocks and options, are not being traded between each other but between them a market maker. You are buying and selling your shares with a private company, not with another investor. This company is called a market maker.

Market makers offer, by law, a price at least as good as you would get from a stock exchange. On top of this they make themselves a profit out of your trades, and on top of that they pay millions of dollars to the brokerages. How do they do that? The primary way they do it by transacting in dark pools. A market maker can sell you shares at $10.00 they bought for $9.996 and buy shares from you at $9.99 then sell them at $9.994. You were never going to get that fractional amount anyway due to regulations of the US government, so the loser here is the exchange (or you, if you want to blame the government.)

Market makers also operate on exchanges, but spreads are so tight nowadays that they don’t realistically make much money on the spread itself as commonly taught. They make their money on exchanges mostly by getting paid from the exchanges in the form of rebates. To put it simply: the stock exchanges charge participants who take liquidity, and give some of that fee to the participants who provide liquidity in the form of rebates. This is actually the reason why the spreads are so tight: because there’s more money in the rebates than in the spreads, so it encourages market makers to compete for the orders thereby providing spreads so tight they don’t make much money from the spread itself.

On top of this, market makers have a very slight lead on pricing and trends because they are the ones executing the trades. They know what will happen before it happens. There are regulations restricting their ability to abuse this, but the consistent fines they receive for abusing it demonstrates that it’s more profitable to abuse it and pay the fines than it is to not abuse it at all. To be fair though, they’re scalping half a cent here and there billions of times — it’s high volume, small scale abuse, it probably doesn’t affect you in a noticeable way.

The market makers see the stock market in a different way, for them its all about volatility, about balancing risk. They use sophisticated computer algorithms to continuously balance their risk. It doesn’t matter to the market maker if the stock market goes up or down because whenever they take one position, they automatically hedge with an opposing position as determined by AI. That opposing position does not necessarily have to be in the same stock, it’s spread across their entire account so their entire account is always risk-neutral.

Much of the trading on the US market are automated hedging and volatility balancing trades made by computers, not trades of investors.

Side note: dark pools have market makers too — market makers for market makers!

Shorting stocks

Shorting a stock means you sell a stock you don’t own. To do this you must borrow the stock from someone who has it, sell the borrowed stock, and later buy it back and give it back to them. The logistics is handled by your broker. Shorting stocks is extremely risky because there is unlimited loss potential (a stock can only go down zero, but it can go up to infinity.)

Even if you have $1,000,000 and you take a fairly small $50,000 short position, the most you can make is $50,000 if the stock goes down to zero (the company declares bankruptcy) but the most you can lose is… well if the stock goes up 100x like GME did then you’d lose $5,000,000. Even if this 100x gain only happened temporarily it doesn’t matter, your broker would liquidate your entire account and you’d be left with nothing. If the gain happened overnight while it was impossible to liquidate then you’d be given a bill in the morning of $4,000,000 that you owe to the broker. Bye bye life. This is how suicides happen.

Recently there’s been a lot of talk that shorting should be illegal, encouraged by the recent GameStop (GME) mania because GME was reported to be shorted more than 100% of float. That means there were more shares sold short than existed on the public exchanges. You might wonder how it’s possible for a stock to be shorted more than 100%, but the answer is not so mysterious: if I have 1 share and lend it to someone who shorts it, the second buyer can lend it to another person who shorts it… so 1 share can easily be shorted multiple times.

Realistically there’s no way to get rid of shorting because it’s an integral part of the market. Brokers make epic money by allowing their customers to short since they get paid collateral at a negative interest rate, so they’re essentially being paid to borrow money. Low-fee index funds make most of their money lending their shares in the same way. And all kinds of institutions use shorting to hedge.

Most shorting is not speculative, it’s mostly not someone shorting the share because they want to profit off the share price going down. Most of it is for hedging.

According to the SEC, trades marked as short constitute 49% of trade volume [source]. Let that sink in for a minute…

What is causing this? Some part is due to the fact that much of the stock market trades are hedging and volatility balancing trades, which are by nature going to be around 50/50 long and short. It could also be the way in which the short shares are reported. If the market makers are reporting temporary short positions they make from trading the bid-ask spread then this could result in an upside-down reporting where many of the buy orders from traders are reported as short by the market maker, since they are short the stock to sell it to the buying trader. You can see how that makes the short reporting almost worthless.

Options & Market Makers

A stock option is a contract that allows the buyer of the option to buy (call option) or sell (put option) a stock at a specific price (called the ‘strike’ price) up until the expiration date of the option. An option is a contract between the buyer and the seller, so at any point in time there are exactly the same number of bought and sold options for the same contract (a contract for a specific stock, strike price and date.)

I won’t go into details on how options work because you can easily find a thousand articles explaining that with a quick Google search. What I will explain to you is that the person on the other side of that options trade is… you guessed it… a market maker!

Stock options cannot be traded in dark pools but have to be traded on public exchanges due to regulations. But that’s okay, market makers use exchanges just as much as they use dark pools.

As I stated above, market makers are not in the business of speculating on the movement of the stock market. Their business is making money, not sometimes making money and sometimes losing money!

Let’s say there’s a stock AAA that is currently at $10. You speculate it’ll go up to $15 so you buy a call option at $13 for $1 (this means you have the right to buy the stock in future for $13.) The stock AAA does indeed go up to $15 and you sell your call option (in most cases right back to the market maker) for $2, making a 100% gain. Lucky you! Most people assume that some unlucky bugger who sold you that call option lost money. That might have been how it worked once upon a time, but today it tends to go something like this:

This is a simplification, but let’s say I sell you that option. I monitor stock AAA with my fancy computer. If stock AAA touches the option contract’s strike price of $13 I buy the stock. If it goes below $13 I sell the stock. So if the stock goes down to $9 I get my premium of $1 and the option expires worthless. If the stock goes up to $15, well my fancy computer bought it at $13, remember? So I buy the option back from you at $2, I make the $2 back from my underlying stock position, and I still get my $1. Whatever happens I still get my $1. I can’t lose money.

Remember I said that market makers only care about volatility? The above was a simplification because in reality I can get screwed by the volatility. In this case the volatility is the number of times the prices fluctuates around the strike price. Every time it passes over the strike price I need to buy the underlying stock, and every time it goes below I need to sell the underlying stock. Each time I do this I lose a little bit of money because of the bid-ask spread. Luckily, if I’m a market maker I have access to dark pools, so it’s only a fraction of a cent I’d lose each time, but it adds up. (In reality this dynamic hedging is done in consideration of the volatility of the entire account and over time, not strictly at the strike price, but you get the idea.)

The other concern an options market maker has is the liquidity of the underlying stock. What if something crazy happens and I can’t continuously buy and sell the underlying? That would be a problem.

Hence an options price is dictated by: the cost of mirroring the opposing trade using a ‘synthetic’ (fancy industry term) position in the underlying stock position plus an additional volatility and liquidity risk.

That might make you think, at least it made me think… if market makers can just mirror an option in synthetic positions using dynamic hedging, shouldn’t I also use synthetic positions instead of trading options? And the answer is: no. It would cost me more to maintain the synthetic position than the price of the option since I don’t have access to dark pools, sub-cent trades, preferential short interest rates, etc. So the market makers are actually providing a pretty good service because by proxy I’m getting access to those services by buying options from them.

Option volume is currently (it’s February 2021) at record highs. We know that when someone buys or sells an option, it’s almost always a market maker on the other side of the trade, and we know that market makers don’t take risk from the options they buy or sell but instead keep dynamically hedged ‘synthetic’ positions in the underlying stock. How much of market activity is then due to the high options volume? And does this have an effect on the price of the stocks?

A lot, and yes.

Buying call options causes the market maker to buy the underlying position as the stock price rises, and sell it as the stock price drops. Retail traders love buying call options. Is this causing inflated prices? Probably. How will it end? Badly. It’ll exaggerate upward price movements and also exaggerate downward price movements.

Closing statement

I hope you enjoyed finding out that nothing is as it seems. If it’s any consolation, I’ve found that knowing all of this makes zero difference to how I trade, except that I no longer have to feel bad for the person on the other side of my options trades.

In my next article in this series I intend to go into the Hong Kong market — that’s a whole different story! Stay tuned!

Alasdair.com

☯ Magician ⚔ Sorcerer ☀ Shaman ☤ Alchemist ♚ Baron of Blackness

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