Written by Tanner Buck
Investopedia defines market makers as “a firm or individual who actively quotes two-sided markets in a particular security by providing bids and offers along with the market size of each.”(Investopedia). Market makers being both the buyer and seller of a particular security provide liquidity, the availability of these securities on both sides of the market. What if through manipulating the liquidity that they provide, market makers were able to manipulate price? This is the central thesis of market maker theory. Simply put, market makers are the providers of liquidity, are knowledgeable about the concepts that average traders utilize and will use their vast capital to create a dichotomy between the retail trader and the market maker. Is the market maker theory correct? One cannot say for certain, but considering that anyone can enter the market with any amount, it is unlikely. However, hearing from people who believe it is correct can provide a new perspective on price action, and possibly help determine the direction of the market.
On their website Fidelity states, “if there is one critical application of Dow theory to know about, it is that the averages must confirm one another.” Essentially, Dow theory roughly states that all corresponding averages ( e.g. NASDAQ,DJIA,SPX ) must confirm each other’s price movements by breaking the same highs and lows in order for a general market direction to be indicated. Dow theory builds off of the Efficient Market Hypothesis, or the idea that price reflects all available information, heavily implying that it is impossible to “beat the market” as price should only fluctuate to new information. Dow theory heavily plays off of the idea that every market is interconnected. Which brings up the question: why would separate markets interconnect? Simply put, every market is reflecting the same economic experience. For example: if the interest rates rose, this would devalue bonds, which return the same percentage yearly, so the bond market would tend towards lower prices. Furthermore, with rising interest rates, companies are less likely to take out loans for expansionary purposes, which reduces the growth rate of a company, making their stock tend towards lower prices. Interest rates are the driving factor in this situation, and the stock and bond markets are positively correlated. SMT Divergence is essentially Dow theory through a market maker theorist’s perspective.
Micheal Huddleston, a financial expert, believes that the markets are completely controlled, and one of the fundamental tools he created is SMT Divergence. SMT Divergence (standing for “smart money tool divergence”) is essentially a derivative of Dow theory. There are two main differences between Dow theory and SMT divergence. The first is that SMT divergence relies more heavily on the negatively correlated relationship between the United States Dollar index (denoted USDX) and the largest 500 stocks in the United States (denoted S&P 500 or SPX). Secondly, through SMT divergence, market maker theorists see the difference between correlated averages as price manipulation not economic indecisiveness. For example, if two major stock indices were trending upwards and one was trending downward, Dow theory would imply that there is no indicated direction, but SMT divergence would suggest there is an upward trend because the price of the one downward trending indice is being manipulated.
On October 17, 2023, the three most prominent stock indices(SPX, DJIA, NASDAQ) saw uncorrelated price action. From Tradingview’s charts, SPX and DJIA created new short term highs in price, but NASDAQ failed to create a new short term high. If the correlated averages don’t move in the same direction through market maker theory it can be interpreted as weakness or strength in the overall trend of all the indices. So does this demonstrate weakness in SPX and DJIA because they shouldn’t have made a higher short term high? Or does it demonstrate strength because the NASDAQ should follow SPX and DJIA and post a higher high the next day? The answer is outside the scope of this piece. There are simply too many factors at play. SMT divergence shouldn’t be what makes your bias (your bias is what direction you think price should generally go towards), but rather a tool to develop a stronger bias. Market maker theorists would explain that it was a price manipulation upwards to induce new buyers to buy the “break out” of the new high, and grab liquidity from short sellers who would try to recuperate their losses by buying back the positions that they shorted. All of these buy orders would be paired with the large institution’s sell orders and as price trends downwards, buyers become trapped in a losing position.
One of the many implied factors can also be seen through SMT divergence looking at USDX and SPX. On October 17th, SPX created a new high, and wants to trade upwards. At the same time, USDX went downwards, but it did so by closing a fair value gap (candlestick pattern, a technical pattern in price which indicates direction) and reaching consequent encroachment of a bullish orderblock (candlestick pattern). So USDX wants to trade upwards as well, but USDX and SPX are negatively correlated so they shouldn’t both trade upwards. That doesn’t make sense. One has to take into account other factors to form a bias, SMT divergence alone will never be enough.
The point of this piece isn’t to go into depth about SMT divergence or price action. It isn’t to promote the use of SMT divergence or to suggest that the markets are manipulated. It isn’t meant to suggest buying or shorting stock. And it isn’t meant to make you want to trade at all. Its purpose is to briefly introduce a new concept that may be helpful when creating a bias. In order to elicit a deeper understanding of markets, we should continue learning various theories and angles and aim to view markets through a broader perspective.
Works Cited
Andrew Bloomenthal. (2023, March 19). Market Maker Definition: What It Means and How They Make Money. https://www.investopedia.com/terms/m/marketmaker.asp
Michael Huddleston [ICT]. (2022, September 10). Ict Mentorship Core Content- Month 04 -Divergence Phantoms [Video]. https://www.youtube.com/watch?v=Xae0VrbkyFk
Michael Huddleston [ICT]. (2023, February 15). February 15, 2023 Live Commentary Am Opening Session [Video]. https://www.youtube.com/watch?v=8YSVu51hUWQ&list=
Michael Huddleston [ICT]. (2022, September 14). Ict Mentorship Core Content- Month 05 -How to use Intermarket Analysis [Video]. https://www.youtube.com/watch?v=4i_hno
Fidelity Active Investor. (2023, July 27). Stock Signal given by the Dow. https://www.fidelity.com/viewpoints/active-investor/dow-days-of-summer
TradingView. (2023, October 27). [Charts]. https://www.tradingview.com/chart