A person or broker-dealer who transacts business on a stock exchange by purchasing and then reselling shares for their own account is known as a market maker. Market makers generate a profit in two different ways: the first is by collecting the spread that exists between the bid price and the asking price of a security; the second is by retaining inventory of shares throughout the trading day.
What Is a Market Maker?
A market maker is a person or broker-dealer who has registered with an exchange to purchase and sell shares of certain stocks directly from other market participants. Market markers may be either individuals or businesses. The orderly trading of the underlying stocks, options, and other products that are listed on financial exchanges are dependent on the market makers that are employed by such exchanges.
These days, the majority of exchanges do their business electronically and enable a diverse range of people and organizations to participate in market-making for a specific stock. This encourages competition by leading to the posting of bids and requests on a particular security by a significant number of market makers. This generates a considerable amount of liquidity and depth in the market, which is beneficial to ordinary traders as well as institutions.
Market makers are able to generate profits in two different ways as a result of the service that they provide.
- From harvesting the spread between the bid and ask: Even while the spread only amounts to a few cents per share most of the time, the profits from it may quickly pile up for a company that trades hundreds of thousands or even millions of shares each day.
- From buying or selling when there are significant market imbalances then liquidating that inventory at a later time after aftermarket circumstances have stabilized
Note: The structure of some of the trades is a little bit different. An individual designated market maker (DMM), which was originally known as a specialist, is allocated to each security on the New York Stock Exchange (NYSE), for instance, in order to offer increased liquidity, depth, and price discovery.
Equities Market Makers
The history of equity market makers goes back quite a ways. The vintage movies about Wall Street provide a look back at the time period in question. In those days, brokerages would first phone in their orders to the exchange, and then the experts working on the floor of the exchange would attempt to match those orders with a willing counterparty. And in the event that there wasn’t one, the expert would purchase or sell the stock directly from their own stock if there was none available.
Things have developed in a new direction as a result of the shift to digital marketplaces. Today, there are hundreds, if not thousands, of market makers, both human and computerized, offering services to different stock exchanges. These market makers are responsible for determining the prices at which stocks are traded. These may vary from major banks or broker-dealers that make markets in thousands of different securities to individuals or specialized organizations that focus on market-making for just a few distinct equities. Large banks or broker-dealers are examples of the former.
Options Market Makers
The practice of developing markets in options is a phenomenon that emerged much more recently. It is impossible for a person to construct a wide market throughout an entire options market since each individual listed firm might have dozens or even hundreds of different related options contracts. These options contracts can have varied strike prices and expiration dates.
As a consequence of this, the invention of the Black-Scholes option pricing model was an essential component in the expansion of the options market. Because of this, computers were able to swiftly establish a price that was fair for a variety of options contracts. These days, options market makers are equipped with a sophisticated set of pricing models and risk management algorithms, which allow them to deliver sufficient liquidity even when the market circumstances are volatile and constantly shifting.
Who Are Market Makers?
Market makers may be persons or broker-dealers who fulfill a certain set of standards for education, training, enough capital, and other related topics. Market makers may participate in the buying and selling of securities.
There is a diverse array of participants in the market, ranging from large banks and organizations to specialist stores and even private people. There is ample space for wholesalers and other companies in addition to the investment banks that are already active, such as JPMorgan (JPM).
How Market Making Works
The bid and the asking price for a stock are both posted by market makers at the same time. Once an offer has been placed, a market maker has the responsibility to fulfill that offer if a trader expresses interest in doing business at that price. Because of this, there is a dependable environment created for traders, as they are able to see via level two quotes just how much of a bid and ask is available at a variety of different prices.
Market makers will conduct dozens upon dozens of purchases and sales of the same underlying securities during the course of the trading day. If a market maker’s efforts are effective, they will generate a profit by selling shares at an average price that is somewhat higher than the price at which the shares were obtained.
How Market Makers Make Money
Market makers primarily profit from two different revenue streams.
1. Collecting the Spread
The first method is to profit from the difference in price between the buy and sell prices of a stock. Let’s say that one share of a corporation now costs $10. A market maker may put up a bid to acquire 1,000 shares at $9.90 and an offer to sell 1,000 shares at $10.10 on the same trading platform. After both orders have been fulfilled, the market maker will have acquired 1,000 shares at $9.90 and sold them at $10.10, resulting in a profit of 20 cents per share, or $200 total.
2. Taking on Inventory
The acquisition of inventory is the second primary means through which market makers generate revenue. When there is an imbalance in the supply or demand of a stock, market makers will often amass a significant stake in the asset. Market makers are often the buyers when there is a stampede to exit a stock, such as when there is a panic selling after a bad news release. In this scenario, the crowd is rushing to get out of the stock. Once things have settled down, the market maker will be able to gradually offload the inventory at prices that are more favorable, making a return for their willingness to absorb risk during the panic selling.
Please keep in mind that market creation is not the same thing as arbitrage. By being prepared to purchase and sell under unstable market situations, market makers expose themselves to a significant amount of risk. It is possible for market makers to incur enormous losses while holding inventory of quickly decreasing equities if, for instance, the price of a company’s shares plummets and then continues to decrease after the first drop.
Market Making Signals
There is a school of thought among traders who believe that market makers communicate with one another through signals. When it comes to the planning and carrying out of their deals, market makers are not permitted, legally speaking, to collaborate.
Despite this, there is a widespread belief that market makers engage in certain behaviors, such as doing transactions with a modest transaction size, in order to provide other market players with a clue about the forthcoming activity. This is something that might happen with firms that have little market capitalization or with penny stocks, but there is no evidence to suggest that this is a prevalent problem with the majority of companies that are listed on the key stock exchanges in the United States.
Hypothetical Example of a Market Maker’s Day
Let’s put ourselves in the shoes of a market maker for Apple (AAPL) shares on the day of one of the company’s product events and try to picture how trading may proceed. There is a lot of speculation about what new products Apple would present first thing in the morning. Traders are vying to get their hands on Apple shares before the event.
Because there is a substantially higher demand than there is the supply of stock, the market maker is forced to sell a major portion of their inventory to retail investors at prices that are gradually becoming higher. This is a crucial market function since very few other traders desire to sell before the product launch; nonetheless, a market maker is obligated to supply both a bid and an ask price regardless of the circumstances of the market.
The afternoon has arrived, and the event turns out to be a letdown. Because the core Apple products do not have any ground-breaking new capabilities, investors are losing interest in the company’s narrative. There is now a frenzy to unload Apple shares, but there are very few buyers in the market. except for the one who makes the market. As the price of Apple shares continues to fall, the market maker is a consistent buyer of those shares even as traders work to sell their holdings. In this manner, the market maker replenishes their stock of Apple shares, which had been sold earlier in the morning.
Because they were prepared to sell to the market in the morning and purchase back in the afternoon when the majority of traders were heading the other way, the market maker in this example earned a significant profit from their willingness to sell to the market in the morning.
However, the person who makes the market is vulnerable to danger. If the product introduction had been successful, Apple share prices may have maintained their upward trend, putting the market maker on the losing side of the event. In exchange for the opportunity to profit from the spread that exists between buy and sell transactions throughout the day, market makers are willing to take on this significant risk.
Impact of Market Makers on the Stock Market
As the above illustration demonstrates, market makers perform an extremely important job for stock exchanges. They are eager to purchase and sell stocks even when market circumstances are volatile and few other individuals are willing to participate in the market. For instance, if a firm fails to meet profits expectations, investors will sell their shares in droves. Who is going to be willing to purchase through such grueling price reductions? Market makers.
Market makers not only act as a buyer or sellers of last resort, but they also work to maintain the gap between the bid and ask prices as small as possible. When it comes to widely held and highly liquid equities, the difference between the bid and the asking price is often just a cent or two, which helps reduce slippage for retail traders.
This is in sharp contrast to less popular securities, which have a far smaller number of market makers due to their lower trading volume. Bid-ask spreads may range as high as a dollar a share or even more in low-capitalization, low-volume businesses with limited market-making capability. This can result in large transaction expenses for retail traders.
Bottom Line
Market makers generate profits by taking risks, namely betting that they will be able to resell the shares that they buy at a higher price than they paid for them. Their activities serve an essential part in the structure of the market, assuring that stocks always have a ready buyer or seller at a price that is acceptable regardless of the state of the market.
FAQs
Are all brokerages market makers?
- No, not all brokerages are market makers. The main responsibility of a broker is to transmit orders received from clients to the relevant stock exchanges, in addition to performing any and all back-office and other support duties that may be required to make trades possible. On the other hand, the main objective of a market maker is to purchase and sell securities on behalf of other traders and investors.
Is market making legal?
- Yes, market-making is legal. In addition to being perfectly legal, doing so is very necessary for the efficient operation of the financial markets. Retail traders would need to pay for higher spreads on their transactions in order to purchase and sell stock in the absence of professionals who provide competitive buy and sell prices.
Like all traders, market makers might conduct themselves unlawfully. As an example of one sort of market manipulation, a presentation given by the SEC depicted a scenario in which market makers controlled the float of a firm and then unilaterally adjusted prices to benefit themselves. Market making as an activity, on the other hand, is not illegal so long as participants adhere to the guidelines set out by the SEC and the stock exchanges in which they trade.
How can I become a market maker?
After completing the necessary training and getting the necessary certification, some stock exchanges let professional traders and broker-dealers become market makers. For instance, the Archipelago platform of the New York Stock Exchange (NYSE Arca) includes a program that enables operators with adequate education, funds, and training to become market makers in specifically listed shares. This program is called “Market Maker Access.”
