What it means
A market maker is a firm that continuously posts prices at which it will buy and sell a stock, earning the gap between them. Exchanges and regulators have historically required market makers to keep a quote in the market at all times.
When a market maker wants to step back, for example during extreme volatility, it can satisfy the rule by leaving a stub quote that is so far from the market that nobody should hit it. A typical stub quote on a stock trading around $50 might be a bid of $0.01 and an offer of $99,999.99.
In normal conditions, other market makers and investors post more sensible quotes, so the stub sits unused. The stub only matters if all the sensible quotes disappear at once.
That is what happened in the sudden market drop of May 2010, when liquidity (the availability of willing buyers and sellers) vanished from some stocks. Market orders to sell found no real bids, so they executed against stub quotes at prices as low as one cent.
Many of those trades were later cancelled as clearly erroneous. Regulators responded with stricter rules.
Market makers are now generally required to quote within a set range of the prevailing best prices, which makes stubs less likely, and exchanges introduced circuit breakers that pause trading in a stock that moves too far too fast. These changes target the specific weakness that stub quotes exposed.
For a non-specialist, the lesson is about order types. A market order accepts whatever price is available, which can be disastrous if the book is empty, whereas a limit order sets the worst price you will accept.
Investors who trade in volatile conditions are usually better protected by limit orders. Stub quotes are an example of a rule meant to guarantee liquidity that instead created hidden fragility.
They show how market structure can matter as much as the companies being traded.
In practice
Real-world examples.
Example
A market maker in a mid-sized stock wishes to withdraw during a news event but must keep a quote. It posts a bid of $0.01 and an offer of $9,999, which no sensible trader would take. Once conditions settle, it replaces the stub with a normal two-sided quote.
Example
During a fast market fall, an investor places a market order to sell shares in an exchange traded fund. The order meets a stub bid because the real bids have been withdrawn, and it executes at a tiny fraction of the previous price. The exchange later reviews the trade and cancels it as clearly erroneous.
Example
A broker's compliance team reviews its clients' stop-loss orders, which turn into market orders when a price is hit. It decides to recommend limit orders for illiquid stocks, to avoid clients being filled against stubs when the market gaps down.
Formula
Calculation
Loss from trading against a stub = (fair price - stub price) x number of shares
Suppose a stock fairly worth $50 has only a stub bid of $0.01 left in the market, and an investor submits a market order to sell 1,000 shares. The proceeds are 1,000 x $0.01 = $10, compared with 1,000 x $50 = $50,000 at the fair price. The loss is $50,000 - $10 = $49,990. A limit order to sell at $45 or better would have simply not been filled.Case study
Seen in the real world.
Northgate Securities is an illustrative, fictional brokerage that handled orders for thousands of retail clients. On a volatile morning, one of its clients, a retiree, had a stop-loss order on an exchange traded fund bought at $60, designed to sell if the price fell to $54.
A sharp fall triggered the stop, which became a market order, but nearly all the real bids had been withdrawn. The order was filled in part against a stub bid at $0.05 and the client's shares were sold for a tiny fraction of their value.
The exchange cancelled the trade as clearly erroneous, but the client was left with weeks of uncertainty. Northgate changed its default order type to a limit stop and warned clients about market orders in thin markets. The illustrative lesson is that stub quotes expose the risk of orders with no price protection.
Watch out
Common mistakes.
- Assuming that a displayed bid is always a real price at which you can sell, when it may be a stub that was never intended to trade.
- Using market orders in fast or thinly traded conditions, which can fill at extreme prices.
- Believing that all trades done at stub prices are automatically cancelled, since the rules for cancelling depend on the venue and the size of the move.
Questions
People also ask.
Why do market makers use stub quotes?
They want to avoid trading in turbulent conditions while still meeting the obligation to keep a quote in the market.
Are stub quotes still a problem?
Rules requiring quotes closer to the market and pauses for large moves have reduced the risk, but sudden thin markets can still produce odd prices.
How can an investor protect against stub quotes?
Use limit orders so that the order cannot execute below a price you have chosen.
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