The market-maker spread is the difference between the price at which a market-maker is willing to buy a security and the price at which it is willing to sell the security. The market-maker spread is the difference between the bid and the ask price posted by the market maker for security. It represents the potential profit that the market maker can make from this activity, and it's meant to compensate it for the risk of market-making. The risk inherent in the market can affect the size of the market-maker spread. High volatility or a lack of liquidity in a given security can increase the size of the market-maker spread.
Role Of A Market Maker
Breaking Down Market-Maker Spread
Market makers add to liquidity by being ready to buy and sell designated securities at any time during the trading day. While the spread between the bid and ask is only a few cents, market makers can profit by executing thousands of trades in a day and expertly trading their “book.” However, these profits can be wiped out by volatile markets if the market maker is caught on the wrong side of the trade.
Example of Market-Maker Spread
For example, market maker MM in a stock – let’s call it Alpha – may show a bid and ask price of $10 / $10.05, which means that MM is willing to buy it at $10 and sell it at $10.05. The spread of 5 cents is its profit per share traded. If MM can trade 10,000 shares at the posted bid and ask, its profit from the spread would be $500.
Rather than tracking the price of every single trade in Alpha, MM’s traders will look at the average price of the stock over thousands of trades. If MM is long Alpha shares in its inventory, its traders will strive to ensure that Alpha's average price in its inventory is below the current market price so that its market-making in Alpha is profitable. If MM is short Alpha, the average price should be above the current market price, so that the net short position can be closed out at a profit by buying back Alpha shares at a cheaper price.
Market-maker spreads widen during volatile market periods because of the increased risk of loss. They also widen for stocks that have a low trading volume, poor price visibility, or low liquidity.