If you’ve ever traded stocks, you’ve probably used a market maker. Market makers are the middlemen of the stock market, and in most cases, these are firms, individuals, and or large corporations that facilitate transactions.
For example, if you wanted to buy shares traditionally, you would do so by purchasing the shares at prices set by whoever is willing to sell them. However, finding a seller might be difficult, especially if the company in question is booming – that’s where market makers come in.
Market Makers allow you to buy and sell stocks with ease as they pair up buy and sell orders from traders around the world. In case no one is willing to take the other side of your trade at a specific price, the market maker steps in and acts as a counterparty. In short, investors can trade stocks at prices set by market makers who provide liquidity. In this guide, we will demystify the workings of market makers and how they profit from the pool of retail and institutional traders around the world.
What Are The Roles of a Market Maker?
So far, we have discussed the basic functions of market makers but here are the 3 main ones you should know.
1. Quoting both a buy and sell price
Market makers are responsible for quoting both a buy and sell price for each stock that they trade. The difference between these prices is the spread. This is in contrast to ECNs, who hardly influence prices but simply pair orders.
2. Maintaining a two-sided market
It is the responsibility of the market maker to maintain a two-sided market by continuously buying and selling stocks. This means that they are always ready to buy or sell a stock at the price that they have quoted. If there is insufficient activity in a particular stock, they may be forced to buy or sell the stock at a loss in order to keep their quotes competitive.
3. Charging commissions
In addition, market makers may charge commissions for their services. For example, they may charge a 1% commission on all trades. However, these commissions are charged to their institutional customers and brokers since market makers don’t deal directly with retail investors.
While most people think that the role of the market maker is simply to provide liquidity and ensure that prices are fair and efficient, they also play an important role in the stock market by helping to keep prices stable and making stock trading available to retail investors.
How Do Market Makers Make Money?
So, how exactly do market makers make money?
1. Through Spreads
Market makers buy and sell stocks on behalf of their clients, and they make money from the difference between the bid and ask price (the spread).
The bid price is the highest price that a buyer is willing to pay for a stock, and the ask price is the lowest price that a seller is willing to accept. Market makers can profit from the differences between these two prices.
For example, let’s say that XYZ stock is trading at $9.55 per share. The bid price might be $9.50, and the ask price might be $9.60. The spread, in this case, would be $0.10.
Assume a seller recently sold 1,000 shares using a market order. The seller’s order would be filled by the market maker at a price of $9.50/share (the bid price).
Now assume a buyer is interested in purchasing 1,000 shares with a market order. The buyer’s order would be filled at $9.60/share (the ask price), and the market maker would make a profit equivalent to the difference between the bid and the ask ($0.10/share x 1,000 shares = $100).
Of course, spreads can be much tighter and market makers can still profit due to the high volume of trades they process. Even a fraction of a penny in profits-per-share adds up when a market maker is processing millions or billions of shares in trading volume.
Market makers are essential to the functioning of the stock market and they are rewarded for adding liquidity. Without them, it would be very difficult for buyers and sellers to find each other and trade stocks.
2. Commissions/Fees
But, they can also profit by charging commissions on each trade. However, these fees are charged to brokerages and institutional customers who need liquidity to facilitate their transactions.
At times the profits market makers realize can be magnified by the large trading volume they have.
For example, a market maker can offer a hundred shares for sale at a set price, and at the same time, quote a price at which they want to purchase a hundred units of the same shares.
Now, if someone buys these shares then the market maker would be short a hundred shares. Since there are many participants in the stock market, there are thousands to millions of transactions at these prices set by the market makers. As such, they keep making and compounding profits from the difference between the bid and ask price for each transaction. Simple right?
However, the market makers can decide to alter the bid and ask prices to suit the market conditions and maximize their profits. When this happens, you will usually see the spreads on your trading platform widen. What’s happening in that instance is that market makers are changing their price offerings to possibly mitigate any losses or drawdowns they may be experiencing. For example, if a market maker was long Apple stock at $10 per share, and the price of Apple stock then fell to $9 per share, the market maker would be experiencing a loss. To offset this loss, the market maker might widen the spread on Apple stocks by altering the bid or ask price.
But, the reality is that market makers have deep pockets so in most cases, they are able to withstand massive drawdowns and hold on to losing positions for long periods.
FAQ
Q: Who are the market makers?
Market makers are those that provide liquidity to facilitate transactions in the financial markets. The biggest market makers are typically large banks or securities firms and their role is to provide liquidity and facilitate transactions.
Q: How much do market makers make?
Market makers make money from the difference between the bid and ask price (the spread). The amount they make depends on how many transactions they facilitate and how much they are profiting per transaction. This will vary by market maker.
Q: How do market makers set prices?
Market makers set prices based on supply and demand. If there is more demand for a stock than there is supply, the market maker will increase the price. If there is more supply than there is demand, the market maker will decrease the price.
Q: How many market makers are there?
There are hundreds of market makers, but they do not all make markets for the same securities. The amount of market makers providing liquidity will vary by stock.
Q: Can market makers manipulate stock prices?
Market makers can influence stock prices by buying or selling stocks in large trading volume. However, regulatory bodies aim to prevent any form of exploitation by market makers.
Q: What is the difference between a market maker and an ECN?
An ECN is an electronic communications network that matches buy and sell orders for stocks. Unlike market makers, ECNs do not set their own prices since the buyers and sellers are allowed to set their own prices while the ECN simply acts as a middleman.
