Market Makers: Definition & How They Make Money
A market maker is an individual or broker-dealer that operates on a stock exchange, buying and selling shares for their own account. Market makers earn a profit 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.
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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 directly from other market participants. Financial exchanges rely on market makers to provide orderly trading of the underlying 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 pair 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 (JPM) are involved, but there is plenty of room for wholesalers and other players as well.
How Market Making Works
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. Once 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.
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 simply 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 (AAPL) stock on the day of one of its product events. In the morning, there's a lot of buzz around what new things Apple might unveil. Traders clamor to buy Apple stock ahead of the event.
The market maker, facing significantly more demand for than supply of stock, sells 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 the event is 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.
The market maker, in this case, has made a meaningful profit from being willing to sell to the market in the morning and buy back in the afternoon when the majority of traders were going in the other direction.
However, the market maker is exposed to risk. Had the product launch been a hit, Apple shares could have continued rallying, leaving the market maker on the wrong side of the action. This is a key risk that market makers take in return for earning the spread between buy and sell transactions throughout the day.
Impact of Market Makers on the Stock Market
As the above example demonstrations, market makers provide a pivotal function to stock exchanges. They 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 be an exodus out of the stock. Who is willing to buy during those brutal sell-offs? Market makers.
In addition to being a buyer or seller of last resort, market makers also 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 run a dollar a share or even higher, 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 market structure, ensuring that stocks have a willing buyer or seller at a reasonable price in all market conditions.
FAQs
No, not all brokerages are market makers. The primary role of a broker is to deliver orders from a customer to the stock exchange and provide all the back office and support functions necessary to facilitate those transactions. Whereas, the primary purpose of a market maker is to buy and sell securities from other traders and investors.
Yes, market making is legal. It's not only legal, it's essential to the sound functioning of capital markets. Without professionals that offer competitive buy and sell prices, retail traders would have to pay far larger spreads on their transactions in order to buy and sell stock.
Like all traders, market makers can behave illegally. An SEC presentation highlighted one example where market makers control the float of a company and then adjust prices arbitrarily to their own benefit as a type of market manipulation. However, the act of market making itself is fine as long as participants stay within the rules and regulations of the SEC and stock exchanges.
Some stock exchanges allow professional traders and broker-dealers to become a market maker by going through a certification process. The New York Stock Exchange's Archipelago platform (NYSE Arca), for example, has an application which allows operators with sufficient education, capital, and training to become market makers in individual listed equities.
This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.
Ian leads the investing group Learn more .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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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