The fluctuation in share prices for AIM stocks can be extreme; can you explain how the market works and the role of the market makers in setting prices?

David

Deputy Editor, Tom Sieber replies

Investors in smaller companies are often frustrated about their inability to buy and sell as many shares as they want and at the price they want, particularly when a big announcement comes out.

Market makers are the banks or stockbrokers which commit to trading shares so you can always buy and sell on an exchange during normal market hours. They attract criticism for the role they play in creating frustration for investors.

Their job is more important with AIM and small cap stocks as, unlike their larger counterparts in the FTSE 350, there aren’t always investors lining up to buy or sell shares. In other words, there is less liquidity.

Nick Conyerd, head of market making at Shore Capital, says there are several different factors behind setting a price. ‘The concept of supply and demand is fundamental to the pricing of all securities,’ he comments. ‘Significant news events often generate considerable interest from investors and as such a market maker will respond to the demand that such statements may encourage. Equally, the supply of stock into that demand also dictates how market makers will price the stock.

He adds: ‘The obligation of a market maker to provide liquidity upon request, dictates that regardless of client orders being worked a market maker will at some stage have to make prices on risk. The management of risk, therefore, is also crucial in determining how a market maker responds to a news statement.’

The price you pay to buy a stock is nearly always higher than the price you get quoted to sell a stock. As Conyerd suggests, the spread between the two is the compensation a market maker gets for the risk of holding shares.

After all they may see a decline in the value of a stock after it has been purchased from a seller and before it is sold to a buyer. This is even before you consider that market making is a commercial activity and the spread is where the money is made.

Another factor to weigh is that market makers, which usually only hold a modest number of shares, will set their price at a level which they know they will be able to both buy and sell stock.

You may find it difficult to buy shares which are rising sharply, but this is likely because the market makers themselves are struggling to find sellers from whom to buy stock.

Regulation has improved the situation for retail investors, effectively pushing brokers and market makers to deliver the best outcome for clients, however the nature of the small cap market and the more limited liquidity in small cap shares means both the volatility and spreads will be higher.

This can be particularly true when there are only one or two market makers in a stock, with the limited competition reducing the incentive to keep spreads lower.

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Please note, we only provide information and we do not provide financial advice. We cannot comment on individual stocks, bonds, investment trusts, ETFs or funds. If you’re unsure please consult a suitably qualified financial adviser.

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