A market maker is an individual or broker-dealer that operates in the peripherals of a stock exchange, buying and selling shares for their own account. Market makers can earn profits both from collecting the spread between the bid and ask prices of a security and also from holding inventory of shares throughout the trading day.
What Is a Market Maker?
A market marker is an individual or broker-dealer that has registered with an exchange to buy and sell shares of given stocks in an effort to promote liquidity on certain tickers. Financial exchanges rely on market makers to provide orderly trading of the stocks, options, and other products listed on their platforms.
Nowadays, most exchanges operate digitally and allow a variety of individuals and institutions to make markets in a given stock. This fosters competition, with a large number of market makers all posting bids and asks on a given security. This creates significant liquidity and market depth, which benefits retail traders and institutions alike.
In return for providing this service, market makers earn a profit in two ways.
- From harvesting the spread between the bid and ask: While this spread is typically just pennies per share, this profit can add up on a stock trading hundreds of thousands or even millions of shares a day.
- From buying or selling when there are significant market imbalances and then selling off that inventory later when conditions settle down
Note: Some exchanges use a slightly different structure. The New York Stock Exchange, for example, has an individual designated market maker (DMM), formerly known as a specialist, assigned to each security to provide greater liquidity, depth, and price discovery. (Source: nyse.com)
Equities Market Makers
Equity market makers have a long history. The old Wall Street movies give a perspective of this past era. In that day, brokerages would call in orders to the exchange and then specialists on the floor of the exchange would run around pairing those orders with a willing counterparty. And, if there wasn't one, the specialist would buy or sell the stock themselves out of their own inventory.
With the transition to digital markets, things have evolved. Today, there's hundreds—if not thousands—of market makers, both human and digital, providing services to various stock exchanges. These can range from large banks or broker-dealers making markets in thousands of securities to individuals or niche firms that concentrate in market making just a few different stocks.
Options Market Makers
Option market making is a much more recent phenomenon. Given that each individual listed company can have dozens or hundreds of different corresponding options contracts with varying strike prices and expiries, it's difficult for a human to make a broad market across an entire option market.
Thus, the creation of the Black-Scholes option pricing model was integral in the development of options markets. This allowed computers to quickly calculate a reasonable price for a wide range of different options contracts. Nowadays, options market makers have a sophisticated series of pricing models and risk management algorithms to help offer reasonable liquidity even in fast-changing market conditions.
Who Are Market Makers?
Market makers can either be individuals or broker-dealers who meet a certain set of requirements around education, training, capital adequacy, and so on.
There are a wide range of market makers from big banks and institutions down to specialized shops and individuals. Big investment banks such as JPMorgan are involved, but there is plenty of room for wholesalers and other players as well.
How Market Making Works
Typically, market makers simultaneously post both a bid and ask for a stock. Once posted, a market maker has an obligation to honor that offer if a trader wants to transact at that price. This creates a reliable ecosystem for traders, since they can see through level two quotations just how much bid and ask is available at varying prices.
Throughout the day, market makers will be both buying and selling the same underlying security countless times. If successful, a market maker's operations will turn a profit by selling shares at a marginally higher average price than they were purchased at.
How Market Makers Make Money
Market makers have two primary ways of making money.
1. Collecting the Spread
The first is from collecting the spread between the bid and the ask on a stock. Say a company is trading at $10 per share. A market maker may post a bid to buy 1,000 shares at $9.90 and an offer to sell 1,000 shares at $10.10. If both orders fill, the market maker will have bought 1,000 shares at $9.90 and sold at $10.10, making a 20 cent per share ($200) profit.
Of course, there's no guarantee that offsetting orders will be filled, and there's a risk that a market maker gets stuck with a large number of shares of a stock that are worth much less than he's paid for them if a price is trending lower. But over time, market making at different levels for a single stock, and market making on a large volume of stocks will hopefully yield profits from spreads that offset losses experienced elsewhere.
2. Taking on Inventory
The other big way market makers earn money is through taking on inventory. When there is a supply or demand imbalance in a stock, market makers will often accumulate a large position in an equity. When there is panic selling following a negative news announcement, for example, market makers are often the people buying as the crowd rushes to get out of the stock. Once things calm down, the market maker can slowly unload the inventory at more favorable prices, earning a profit for their willingness to absorb the risk during the panic selling.
Note: Market making is not a form of arbitrage. Market makers take considerable risk by being willing to buy and sell in volatile market conditions. Sometimes, if a company's stock plunges and then continues to decline, for example, market makers can suffer outsized losses holding inventory of a rapidly falling equity.
Market Making Signals
Some traders speculate that market makers have signals to work together with each other. Legally, market makers cannot cooperate when planning and executing their trades.
However, rumors abound that market makers engage in behavior, such as executing small transaction size trades, as a hint to other market participants about future activity. This might be possible in small capitalization or penny stocks, but there's little evidence of it being a widespread issue with most companies listed on the primary American stock exchanges.
Hypothetical Example of a Market Maker's Day
Let's imagine how trading might go for a market maker in Apple Inc. stock on the day of one of its product events. One morning there might be a lot of buzz around what new things Apple might unveil. Traders clamor to buy Apple stock ahead of the event.
The market maker, seeing significantly more demand than supply for Apple stock, sets their bid and ask range higher than the previous market close, anticipating a price level that would see trading in both directions.
In the event that Apple shares continue to get bid higher after market open, the market maker may end up selling through much of their inventory to retail investors at steadily increasing prices. This is a useful market function, since few other traders want to sell ahead of the product launch, but a market maker has a duty to provide a bid and ask regardless of market conditions.
Afternoon arrives, and let's say Apple's event was a disappointment. There are no revolutionary features for Apple's mainstay products and traders lose interest in the story. Now there's a rush to sell Apple shares, with few people willing to buy. Except the market maker, that is. The market maker is a steady buyer of Apple shares at declining prices as traders move to unload their positions. In this way, the market maker refills their inventory of Apple shares which had previously been sold in the morning.
In this example situation, it's possible the Apple market maker has earned profits on the day, or suffered losses. Market makers are always exposed to risk. But over the long haul, market making activities are designed to be fruitful, otherwise some might abandon the profession.
Impact of Market Makers on the Stock Market
As the above example demonstrations, market makers provide a pivotal function to stock exchanges. Market makers are willing to buy and sell securities during rapidly-changing conditions when few other people are willing to step in. If a company misses earnings, for example, there will likely be an exodus out of the stock. Who is willing to buy during those brutal sell-offs to temper the chaos? = market makers.
In addition to being a buyer or seller of last resort, market makers also help keep the spread between the bid and ask low. On popular highly-liquid stocks, there is often only a spread of a penny or two between the bid and ask, reducing slippage for retail traders.
That's in stark contrast to less popular securities, where there are far fewer market makers. In low-capitalization, low-volume companies with scarce market-making capacity, bid/ask spreads can be several percentage points wide, leading to significant transaction costs for retail traders.
Bottom Line
Market makers earn profit from taking risk, namely that they will be able to resell shares they purchase at a profit. Their operations play an integral role in the functioning of markets, ensuring that stocks have a willing buyer or seller at a reasonable price in all market conditions.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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