An investor who wishes to buy a stock will typically not spend time and energy searching out a counterparty who wishes to sell the same stock in the same quantity; instead, he will simply go to a broker, who then goes to a “market maker”, to execute the trade. A market maker’s job is to facilitate the buying and selling of stocks, or “make a market” in a particular stock.

For a frequently traded stock, for example, General Electric (tkr: GE), a market maker will have a high degree of confidence that after buying 100 shares of GE from one investor, he could quickly and easily sell those 100 shares to another investor. But the market maker would still like to be paid for his service. He will do this by buying 100 shares of GE at a slightly lower price (the bid) from Investor A and selling 100 shares of GE at a slightly higher price (the ask) to Investor B. After the trade is executed, Investor B owns the 100 shares she wanted, Investor A was able to sell the 100 shares he was looking to unload, and the market maker gets to keep the spread between the bid price and the ask price. Because the market maker’s job in this case was relatively easy, the bid and ask prices were probably very close together, and his “take-home” bid-ask spread was fairly small.

However, what happens if Investor A wants to sell 1,000 shares and Investor B only wants to buy 100? In this case, the market maker might have a harder time matching buyers with sellers while taking on the risk that GE’s stock price could move up or down in the meantime. For this more difficult, riskier job, the market maker will demand a higher bid-ask spread. Similarly, a market maker will demand a higher spread for an infrequently traded stock or during a volatile period in the market, since both scenarios carry greater risks.

Over the last 20 years, bid-ask spreads on stocks have decreased significantly. In 2001, the SEC ordered all stock markets to convert to decimals from fractions, making each stock price increment smaller. This led to dramatically tighter bid-ask spreads. Many people point to smaller bid-ask spreads as an indication of higher liquidity. On the surface, this seems to make sense; more liquid stocks typically have smaller bid-ask spreads than less liquid stocks. But this conclusion leaves out a key piece of the story: the quantity. In addition to bid and ask prices, market makers often show a corresponding bid or ask size on which they are willing to commit. For example, a market maker might quote a bid-ask spread of (bid price) $25.00 to $25.03 (ask price) for a lot of 100 shares of GE. This indicates that the market maker is willing to buy 100 shares of GE at $25.00 and is willing to sell 100 shares of GE at $25.03 (a 3-cent bid-ask spread). For 10,000 shares, the bid-ask spread might be 20 cents. Most people tend to forget about the lot size when they see tighter bid-ask spreads. Investors might assume they can buy their entire share quantity from the market maker at the ask price displayed, but in reality those prices are good for just 100 shares. The market maker is only “committed” on what he is showing, so in our example, he must sell 100 shares at the ask price.

As bid-ask spreads have decreased over the last 20 years, so has the share quantity available at those prices. Ironically, this results in less liquidity, especially for larger market orders, and more turmoil in times of market panic. Since we only know the bid-ask spread displayed for a small quantity, no one has any idea where a larger quantity of shares could trade.

When market sentiment tilts one direction or the other, we end up with an imbalance of buyers and sellers that makes the market maker’s job even more difficult and risky. This is exactly what happened on Monday, August 24 when the Down Jones Industrial Average briefly dropped by over 1,000 points in the first six minutes of trading. As market sentiment tilted negative and more sellers emerged, there were more parties going to market makers looking to sell their shares. In this volatile environment, market makers scrambled to try to execute large orders without exposing themselves to huge risks while more sellers poured in, leading to the sharp price decline.

In reality, a rational human investor who sees the stock’s price drop 20% over a few minutes with no meaningful news would detect an overreaction. In fact, if the entire market were made up of rational investors, the stock would probably not even make such a move in the first place. But, of course, the market is not made up exclusively of rational investors.

Stop-Loss Orders

One popular mechanism among retail investors is a “stop-loss order”. This type of sell order is triggered when a stock drops below a specified threshold. The idea is that an investor can limit her loss on a position. For instance, if an investor has a stop-loss order set 10% below her cost, when the stock drops below that level, it will be sold automatically. However, this does not mean that the investor’s loss is limited to 10%. Imagine an investor had a cost basis of $27 and wanted to implement a stop-loss order if GE were to drop more than 10% to $24.30. GE closed the previous Friday, August 21 at $25, so the stop-loss order would not have been triggered on Friday. On Monday August 24, GE opened at $22.84, and the stop-loss order would have immediately become a market order. Sometime in the next panic-filled six minutes, the order would have been executed somewhere between $22.84 and $19.37. This would mean the investor would face losses of up to 26%! Had she never implemented the stop-loss order, the investor would still own her GE position which currently stands around $25, where it was before the panic. With the stop-loss order, the investor would have sold out of her position at the absolute bottom, only to see the stock recover most of those losses as the rational investors realized that the drop was an over-reaction. In fact, many argue that the popularity of stop-loss orders among retail investors is what led to the panicked declines in the first place.

Because the orders are automatically triggered by a machine, there is no human sanity check done prior to the execution. As the stop-loss orders are executed one after the other, the stock is allowed to free fall until opportunistic investors step in to buy, bringing balance to the order flow.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.