What Is a Market Maker?
The term market maker refers to a firm or individual who actively quotes two-sided markets in a particular security, providing bids and offers (known as asks) along with the market size of each. Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread. They may also make trades for their own accounts, which are known as principal trades.
- A market maker is an individual participant or member firm of an exchange that buys and sells securities for its own account.
- Market makers provide the market with liquidity and depth while profiting from the difference in the bid-ask spread.
- Brokerage houses are the most common types of market makers, providing purchase and sale solutions for investors.
- Market makers are compensated for the risk of holding assets because a security's value may decline between its purchase and sale to another buyer.
- While brokers compete against one another, specialists post bids and asks and ensure they are reported accurately.
Understanding Market Makers
Many market makers are often brokerage houses that provide trading services for investors in an effort to keep financial markets liquid. A market maker can also be an individual trader, who is commonly known as a local. Due to the size of securities needed to facilitate the volume of purchases and sales, the vast majority of market makers work on behalf of large institutions.
Each market maker displays buy and sell quotations for a guaranteed number of shares. Once the market maker receives an order from a buyer, they immediately sell off their position of shares from their own inventory. This allows them to complete the order. In short, market making facilitates a smoother flow of financial markets by making it easier for investors and traders to buy and sell. Without market making, there may be insufficient transactions and fewer investment activities.
A market maker must commit to continuously quoting prices at which it will buy (or bid for) and sell (or ask for) securities. Market makers must also quote the volume in which they're willing to trade along with the frequency of time they will quote at the best bid and best offer prices. Market makers must stick to these parameters at all times, during all market outlooks. When markets become erratic or volatile, market makers must remain disciplined in order to continue facilitating smooth transactions.
How Market Makers Earn Profits
Market makers are compensated for the risk of holding assets because they may see a decline in the value of a security after it has been purchased from a seller and before it's sold to a buyer.
Consequently, they commonly charge the aforementioned spread on each security they cover. For example, when an investor searches for a stock using an online brokerage firm, it might observe a bid price of $100 and an ask price of $100.05. This means the broker purchases the stock for $100, then sells it to prospective buyers for $100.05. Through high-volume trading, a small spread can add up to large daily profits.
Market makers must operate under a given exchange's bylaws, which are approved by a country's securities regulator, such as the Securities and Exchange Commission (SEC). Market makers' rights and responsibilities vary by exchange, and by the type of financial instrument they trade, such as equities or options.
Market Makers vs. Specialists
Many exchanges use a system of market makers, each competing against one another to set the best bid or offer in order to win the business of orders coming in. But some, like the New York Stock Exchange (NYSE), have a specialist system instead. The specialists are essentially lone (and designated) market makers with a monopoly over the order flow in a particular security or securities. Because the NYSE is an auction market, bids and asks are competitively forwarded by investors.
The specialist posts these bids and asks for the entire market to see and ensure that they are reported in an accurate and timely manner. They also make sure that the best price is always maintained, that all marketable trades are executed, and that order is maintained on the floor.
The specialist must also set the opening price for the stock each morning, which can differ from the previous day's closing price based on after-hours news and events. The specialist determines the correct market price based on supply and demand.
Example of Market Maker
Here's a hypothetical example to show how a market maker trades. Let's say there's a market maker in XYZ stock. They may provide a quote of $10.00-$10.05, 100x500. This means that they make a bid (they will buy) for 100 shares for $10.00 and also offer (they will sell) 500 shares at $10.05. Other market participants may then buy (lift the offer) from the MM at $10.05 or sell to them (hit the bid) at $10.00.
Who Are Market Makers and What Do They Do?
A market maker participates in the securities market by providing trading services for investors and boosting liquidity in the market. They specifically provide bids and offers for a particular security in addition to its market size. Market makers typically work for large brokerage houses that profit off of the difference between the bid and ask spread.
How Do Market Makers Work?
A number of market makers operate and compete with each other within securities exchanges to attract the business of investors through setting the most competitive bid and ask offers. In some cases, exchanges like the NYSE use a specialist system where a specialist is the sole market maker who makes all the bids and asks that are visible to the market. A specialist process is conducted to ensure that all marketable trades are executed at a fair price in a timely manner.
How Do Market Makers Earn a Profit?
Market makers earn a profit through the spread between the securities bid and offer price. Because market makers bear the risk of covering a given security, which may drop in price, they are compensated for this risk of holding the assets. For example, consider an investor who sees that Apple stock has a bid price of $50 and an ask price of $50.10. What this means is that the market maker bought the Apple shares for $50 and is selling them for $50.10, earning a profit of $0.10.