Sorry if this post is convoluted. But essentially, how does market making work? Essentially Im trying to understand the mechanics of market making and pricing of stocks. Fundamentally, at some level, prices have to be based on supply and demand of the stocks for price discovery. The designated market maker stands between buyers and sellers and is the buyer or seller of last resort in thin markets. Supposedly, market makers do have some discretion to move prices in an opposite direction to where supply and demand will theoretically move it, in order to 'shake people out', using the so called market maker tricks. But these are short term tricks, because MMs will lose money over the long term being a contrarian to market supply/demand. But how are stocks priced? How are stocks able to make big moves on light volume? My main question is, are prices based on the instantaneous (very short term) buy/sell side imbalance? Or are they based on total historic supply and demand (very long term buy/sell side imbalance based on the inventory of stock held by a market maker)? For example, in the former case, if there is a sudden large imbalance on the sell side all of a sudden, even though the total shares sold represents a small fraction of the total float, if there are no buyers on the other end, the market maker has to move the stock by a large margin very quickly due to sell side imbalance? In a normal market, when there is a sell side imbalance, it is often quickly met with buy side to balance and put a floor on the price to prevent a large dip? Essentially, if there is material development in a stock, it is expected there is large imbalance on either buy or sell side. So there will be noone to keep prices at a certain level in check, so it moves fast? Whereas just people accumulating or distributing stocks, with no material news, there is often a buy or sell side to offset a sudden imbalance? Or is market making in the latter case, based on the total historic inventory of the market maker. So, if say the market maker gets purchased or sold to a certain quantity of stock, they program this move to be = $X discrete price? I dont know if I'm making it clear. Essentially, are prices moved based on very short term sell/buy imbalances or are they based on some fixed formulation based on total float and is related to the historic trading of the stock? What I'm trying to understand is, how light volume can move stocks in either direction? Essentially, this opens up manipulators to move prices during low volume sessions using a small amount of stock, and this new 're-pricing' of the stock sets a new trading range for the next trading session? This will only be a problem if market making was based on very short term buy/sell imabalances. If it was formulaic based on total historic buy/sell as it relates to total float, it will be impossible to move stocks on low volume. I am inclined to think it is based on short term imbalances? So price stability in the market essentially relies on an unlimited and instantaneous supply of buyers or sellers on the opposite end to match sudden supply shocks? So in a market with large supply shocks but without matching opposing buyers or sellers, you have huge price gaps?
That is more of an academic study trying to understand the inner workings from an outside perspective. But it doesnt address the main issue whether prices are moved based on the near term instantaneous order imbalances rather than some set formulation based on the supply demand of the stock with respect to the total float? I see a problem with moving stocks based on very near term order imbalances because it allows manipulators to move stock prices during thin markets. Maybe during a trading day there are millions of shares sold by big institutions that are met by a bunch of smaller buyers to keep the price from tanking. But in say an afterhours trade, or using futures in overnight sessions, manipulators may be able to use less money to move the price a lot. This then sets the new price for the next trading session. This is done quite often. I'm trying to understand how this is possible. For example, last friday, the S&P gapped up because they began gapping the futures in the overnight session. Or maybe you've seen a hundred times how after hours they gap prices during earnings. How is that done? I guess the argument may be, if manipulators gap prices during illiquid hours, but the price is 'mis-priced' based on supply/demand price discovery, then it will be met heavily with buyers or sellers during normal sessions who will then 'adjust' the price back to fair value. But its not always the case. Say there is a good stock where everyone is long. They are long term buy and hold investors. So noone is selling. And a manipulator comes along and uses illiquid hours to gap prices higher based on that short term buy side imbalance causing a price gap higher. But, during the next trading session, there are no sellers to bring the price back down because everyone else who owns the stock are buy & hold types. Essentially such a scenario allows manipulators to gap prices higher and higher on low volume. A similar scenario can be dreamed up for the gap down side for shorts in a name. And just how much imbalance, and with respect to what time frame, moves a stock by how much %? Is there an industry standard here or are all of this proprietary? The markets are basically a black box to me. You have prices to buy or sell but I'm just trying to understand the mechanics behind it. Or maybe each stock has their own proprietary algos and maket making behaviors so there is no one general rule on how stock prices respond to buy or sell side momentum? It depends entirely on the stock, and the market makers and their algos that they programmed for making the markets in that name?
I'm sure there are a number of reasons why this could occur, but one of which comes to mind is the time honored tradition of momentum ignition and liquidity holes. https://edge.credit-suisse.com/edge/Public/Bulletin/Servefile.aspx?FileID=23285&m=923226224