Many retail traders are unaware that market makers frequently work both the bid and ask at the same time. In this post, I explain why these moments occur and why one should try to avoid trading when it’s obvious this is happening.
Note: the “whipsaw chop” action I describe in this post frequently takes place in stocks, stock index futures, energies, metals and many products which have light liquidity (small amounts worked on the bid/ask). While this does happen in treasury futures, it happens much less frequently. This is because there is a lot of liquidity in treasuries most of the time so it’s more difficult for a market making firm to accomplish this type of manipulation.
Market conditions can change very quickly. An influx of money can create a fast paced scenario which moves price substantially in one direction for a short period of time and a withdrawal of that money can create choppy conditions which make it difficult to anticipate direction for the next hour or longer.
Most traders have encountered days when they easily made a decent amount of money during a twenty minute time period and then spent the rest of the day losing it all plus more. One of the main reasons this happens is because they do not recognize a change in conditions (or what I usually refer to as “context” in my material).
A “one way street” occurs because most of the money is going the same way at the same time.
A market hits new highs and there is a sustained move higher and higher for the next ten minutes with small pullbacks or virtually no pullbacks. Why does this happen?
1 – Buyers who are already long buy new highs in an attempt to continue moving price in their direction.
2 – Money which has been sitting on the sidelines waiting for something to happen sees this move and starts buying in an attempt to catch the wave.
3 – Shorts getting squeezed start buying to exit at a loss because they can no longer take the pain.
4 – Many of those shorts reverse and go long in an attempt to catch the wave and make back some of what they just lost.
A chain reaction takes place and the domino effect kicks into gear as buy orders chase buy orders. This is one of the most ideal situations. A day trader is constantly looking for this scenario and attempting to catch a piece of the move if/when it happens.
“Whipsaw chop” generally occurs because no one is committing to much size so the majority of the volume is being moved by market makers looking to capture the bid/ask spread and easily manipulate price.
A market maker is working limit bids at prices of 25, 24 and 23.
The same market maker is also working limit offers at prices of 26, 27 and 28.
He (or more appropriately, the program) is waiting to see which side gets hit first. If he gets filled on his bids, he will cancel the offers and bid higher. If he gets filled on the offers, he will cancel his bids and offer lower.
He is attempting to capture small profits in slow action by manipulating the bids and offers and continuously trapping people on the wrong side.
If you get involved when this type of manipulation is happening, it is difficult and, imo, sometimes impossible to make money in the short-term because you will be the person filling his bids and offers. Once you fill his order, he will push price against you. I’ve had this happen to me enough in life to typically know when a trap is being set and I can usually avoid it although I do still occasionally get suckered into hitting bad prices. When I use a market buy order to hit into an offer and, as soon as I’m filled, the two bids below my entry price instantly disappear, I know I’ve been trapped.
Using the prices mentioned above:
If you buy at 26, the bids at 25 and 24 will disappear and price will quickly be against you. If you sell at 25, the offers at 26 and 27 will disappear and price will quickly be against you.
And if you refuse to exit? Depending on the situation, price will often continue moving against you because the market maker will just keep pushing in one direction until he finally gets filled on the other side.
If you only watch the stock index futures, this is sometimes difficult to see. If you watch the activity in the underlying stocks, particularly the ones which account for most of the index movement, it can often be crystal clear. Watching the price action along with the time and sales for individual stocks can be quite illuminating even if you have no intention of trading stocks.
This “trap” situation occurs multiple times on any given day. The bids look weak but as soon as market sell orders hit those bids, the offers magically vanish and price moves higher…or vice versa.
In order to gain consistency, you have to focus on anticipating the one way streets and avoiding the periods of back and forth “whipsaw” chop.