What Is it to Make a Market?
Making a market is an action whereby a dealer or market maker stands by ready to make a two-sided quote. This quote indicates they are willing and able to either buy or sell a particular security at their quoted bid and ask price.
Being able to make a market in this way allows for liquid and efficient markets. Markets can be made on anything that is exchanged, from stocks and other securities to currency exchange rates, interest rates, commodities, and so on.
- To make a market means to be willing to trade a security against a counterparty by producing a firm bid to buy and offer to sell.
- Market makers display buy and sell quotes for a guaranteed number of shares, take orders from buyers, and then sell shares from their inventory to complete the order.
- Those that make markets hold on to large inventories of securities at all times so that they can always satisfy investor demand, quickly, and at competitive prices—regardless if it is a buy or sell order.
- Being a market maker requires a higher risk tolerance than a conventional brokerage, because of needing to hold large amounts of a security at any given time.
Understanding Make a Market
To make a market is to display a bid (where you are willing to buy) and an ask or offer (where you are willing to sell). For instance, if you were a grocer and were asked to make a market on the price of an apple, you may indicate $0.10 - $0.50 ("ten cents bid at fifty cents"). This means you'd be willing to buy an apple for a dime, and sell an apple for half a dollar. The key point is that when asked to make a market, you do not necessarily know in advance if the requester is an interested buyer or seller.
Market makers and dealers are the ones that make markets on securities exchanges. Market makers are market participants or member firms of an exchange that buy and sell securities against other counterparties at prices displayed in an exchange’s trading system for their own accounts—called principal trades—and for customer accounts—called agency trades. Market makers can enter and adjust quotes to buy or sell, enter, and execute orders, and clear those orders.
Market makers exist under rules created by stock exchanges approved by a securities regulator. In the U.S., the Securities and Exchange Commission (SEC) is the main regulator of the exchanges. Market maker rights and responsibilities vary by exchange and the market within an exchange such as equities or options.
Market makers make money via the spread on each security they cover—namely, the difference between the bid and ask price; they also typically charge investors fees to use their services.
How a Market Maker Works
In order to make a market, a brokerage firm must be willing to hold a disproportionately large amount of a given security so it can satisfy a high volume of market orders in a matter of seconds at competitive prices. In contrast to a conventional brokerage, being a market maker requires a higher risk tolerance because of the high amounts of a given security that a market maker must hold.
Market makers promote market efficiency by keeping markets liquid. To ensure impartiality for their clients, brokerage houses that function as market makers are legally required to separate their market-making activities from their brokerage sales operations.
Market makers smooth out the process of trading by making it easier for investors and traders to buy and sell securities; no market makers could mean not enough transactions and not enough trading going on to keep the process fluid.
Market Makers Facilitate Liquidity
If investors are selling, market makers are obligated to keep buying, and vice versa. They are supposed to take the opposite side of whatever trades are being conducted at any given point in time. As such, market makers satisfy the market demand for securities and facilitate their circulation. The NASDAQ, for example, relies on market makers within its network to ensure efficient trading.
Market makers profit through the market maker spread, not from whether a security goes up or down. They are supposed to buy or sell securities according to what kind of trades are being placed, not according to whether they think prices will go up or down.