What it means
The core service is immediacy. If you want to sell 5,000 shares right now and no natural buyer exists at this second, a market maker buys them from you and carries the position until a buyer shows up.
You get certainty of execution, and the market maker gets paid for providing it. The compensation is the bid-ask spread.
The market maker quotes a bid, the price at which it will buy, and an ask, the higher price at which it will sell, and it hopes to buy at one and sell at the other many times a day. The spread is narrow on heavily traded shares and wide on illiquid ones, which reflects the risk of being stuck with the stock.
The risk is inventory. If a market maker buys from a stream of sellers just before bad news breaks, it holds a losing position it never wanted, and the accumulated spread from hundreds of small trades can be erased by a single sharp move.
Hedging and rapid position management are therefore central to the business. Market makers matter to ordinary businesses in two visible ways.
Companies with a market maker committed to their shares typically have narrower spreads and easier trading, which lowers the cost of capital, and some smaller listings pay for designated market-making support precisely for this reason. There are variants worth distinguishing.
Designated market makers have formal obligations to an exchange or issuer, while electronic proprietary trading firms make markets voluntarily and can withdraw at any moment, which is why liquidity can evaporate quickly during stress.
In practice
Real-world examples.
Example
A newly listed engineering company with thin trading volume appoints a designated market maker to quote continuous prices. The spread narrows from about 2% to 0.6%, and institutional investors who had avoided the stock begin to build positions.
Example
A pension fund needs to sell a $40m bond holding quickly and asks three dealers for prices. Each acts as a market maker, quoting a bid that reflects both the bond's value and the risk of holding it, and the fund trades at the best of the three.
Example
During a sudden intraday shock, electronic market makers widen their quotes dramatically and reduce size. A retail order that would normally fill within a cent of the midpoint executes twenty cents away, which is the cost of liquidity disappearing.
Think of it
“Market maker is always ready to buy or sell-providing liquidity to the market.
Formula
Calculation
Bid-ask spread = Ask price - Bid price
Spread as a percentage = Spread / Midpoint price
Gross spread revenue = Spread per share x Shares traded on both sides
A market maker quotes a bid of $49.95 and an ask of $50.05 in a mid-cap share. The spread is $50.05 - $49.95 = $0.10, and with a midpoint of $50.00 that is $0.10 / $50.00 = 0.002, or 0.2%.
During one session it buys 120,000 shares at the bid and sells 120,000 shares at the ask. Gross spread revenue is 120,000 x $0.10 = $12,000.
It also ends the day holding 20,000 unsold shares bought at $49.95, and the price closes at $49.65. That inventory loss is 20,000 x $0.30 = $6,000, leaving a net result for the day of $12,000 - $6,000 = $6,000 before costs.Case study
Seen in the real world.
Larkspur Quay Securities is a fictional trading firm used here as an illustrative example. It made markets in about forty mid-cap shares, quoting two-sided prices all day and typically capturing spreads of eight to twelve cents on a few hundred thousand shares.
On an ordinary day the firm earned roughly $40,000 of gross spread across its book. Its actual profit, though, depended almost entirely on how quickly it could offload inventory: positions held past the close were the difference between a good month and a poor one.
One quarter it accumulated a large position in a single company just before a profit warning, and a $310,000 inventory loss consumed several weeks of spread income. In this illustrative telling, Larkspur Quay responded by capping the inventory it would carry in any one name and by hedging concentrated positions with index futures overnight.
Watch out
Common mistakes.
- Assuming the market maker's spread is a hidden fee charged for nothing. It is payment for guaranteeing you can trade immediately and for the risk of holding an unwanted position afterwards.
- Thinking market makers profit whichever way the price moves. They profit from the spread, but they can lose heavily on inventory when prices move against a position they were obliged to take on.
- Believing quoted liquidity is guaranteed to be there when you need it. Most electronic market makers have no obligation to continue quoting and will widen or withdraw during volatile conditions.
Questions
People also ask.
How does a market maker differ from a broker?
A broker matches your order with someone else's and charges a commission, whereas a market maker takes the other side of your trade using its own capital.
Why are spreads wider on some shares than others?
Wider spreads compensate for greater risk, so shares that trade rarely, move sharply, or have a small free float carry wider quotes than heavily traded large companies.
Do market makers exist outside share markets?
Yes, they are central to bond, currency, commodity and options markets, and in many of those markets almost all trading happens through dealers quoting two-sided prices.
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