Market Makers & ECNs

When you get involved in the day trading industry, you hear the term ‘market makers’ thrown around a lot… But what does it really mean?

Who are the market makers?

Why do they matter to Day Traders?

A ‘market maker’ is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. There are over 500 market makers and each competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. This process takes place in mere seconds, which is why you have to be very fast at entering orders on your platform of choice.

So now that you have a clear definition of what a market maker is, how do they make money? What is in it for them?

Market markers earn their money off the buy-sell spread, which is basically the difference between the price at which a market maker is willing to buy a stock and the price that the firm is willing to sell the stock.

An easy way to sum it up in your mind is thinking of the market makers are the players providing liquidity in the market. They are willing to buy when nobody else is buying and sell when nobody else is selling. They drive the action. They are the player at your poker table that is always raising, even when the rest of the table is playing tight and mostly folding. They are creating the action in the game and keeping the pace moving. This is the BASIS of the MOJO Style – Buying when everyone else is selling and selling when everyone else is buying.

ECN’s - A Revolutionary Advancement

ECN is the abbreviation for electronic communication network. An ECN is basically a computerized stock exchange that offers stock traders an alternative to traditional exchanges like the New York Stock Exchange. ECNs were created in 1969 by INSTINET and proliferated greatly during the 80s and 90s, but recently volume has shifted very heavily away from traditional stock exchanges to electronic communication networks.

Today, ECNs account for approximately 30% of total share volume and 40% of the dollar volume traded in NASDAQ securities. ECNs account for approximately 3% of total share and dollar volume in listed securities. In contrast, in 1993, ECNs accounted for only 13% of share volume in NASDAQ securities and only 1.4% of listed share volume. The vast majority of ECN activity currently involves trading in NASDAQ securities during regular trading hours.

ECNs – Who Are They and What Services Do They Provide?

In simplest terms, ECNs bring buyers and sellers together for electronic execution of trades. The electronic communication networks as a whole are known as the LIT or Light pool markets. These are the markets that are available for all of the public to see. This is where about half of all volume transacts in the stock market, and they are open for access to any subscribers with a computer and internet access. Unfortunately few brokerages except for proprietary trading brokerages offer day trading accounts access to these networks. The opposite of LIT markets are dark pool markets. ECNs do not function primarily as dark pools, but some are now offering subscribers access to deeper pools of liquidity by offering some of their own dark pools.

The benefits of transacting over an ECN vs. a traditional exchange market are evident for a stock trader. An ECN seeks to remove the middleman by allowing a transaction to occur directly between market participants. ECNs have been credited with the massive reduction in trading transaction costs over time. Electronic exchanges removed the need for a trader to be on an exchange floor, so besides saving transaction costs, they also opened up market access to millions of traders who now only need a computer and an internet connection to participate in trading.

If a trader uses ECNs, there is transparency to see buy and sell orders in the ECN’s order books. This allows a trader to get an idea of buy interest vs. sell interest in a stock and can give a trader a read on the likely near term price movement. If the trader uses the full suite of popular ECNs, ARCA, BATS, INET they can choose to transact over the one that best suits their liquidity needs, balance fill potential with cost to transact. This gives the trader the highest probability of having the order transacted at the most beneficial price and cost to the trader.

The Most Active ECNs include:

NASDAQ: Including NASDAQ Boston exchange, and NASDAQ Philadelphia exchange
BATS BZX and BYX exchanges
EDGX Direct Edge and EDGA exchanges
NYSE ARCA

Each ECN determines its own fee structure for transactions. It is common practice to pay a rebate to traders for either adding liquidity to its books or for removing it, and to charge a fee for the opposite order type.

Depending on the pricing structure of a particular ECN, rebates offered can be as high as about $.003 per share, and costs can be as high as $.003 per share, but cost cannot be any higher than this by law. Some ECNs also offer incentives to transact higher volume over the network by paying higher rebates or reduced costs to those meeting certain volume thresholds for either adding or removing liquidity.

Because ECNs provide not only an inexpensive transaction medium for traders, but also rebates for certain order types, it is very advantageous for a trader to use a broker that will offer direct market access with pass through fees and rebates.

ECN Facts:

ECN quotes are not "hidden". They can be seen on the Level II Screen.
Only the best ECN Bid or Ask is displayed on regular Level II screens.
Most DAT brokerages have direct subscriptions for several ECNs. Some DAT brokerages have all of them available. This allows for a much faster quote and execution.
When using a DAT platform, you may submit/post direct bids and offers through the direct ECN system only.
When using direct ECN access, you may specify a price and share size; these are limit orders. However, improvements in the ECN routing do allow market orders, reserve orders and even hidden orders. Check with your DAT brokerage to be sure of all possibilities.
Partial fills on the ECN system are common, especially in heavily traded stocks.

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