CFA, Finance, FRM

How does a Market Maker work? | Full Understanding

Who is a Market Maker and what does it mean to ‘Make the Market’?

Within a few taps you can place an order with your brokerage firm to buy or sell shares – the speed and simplicity at which this is done are usually taken for granted. The concept for the day is ‘Making the Market’ and we’re going to take a peek at how the whole mechanism takes place behind the scenes.

In a nutshell, imagine you have 50 shares of Citibank and you speculate that you’ll be better off by selling them one morning. With the absence of market makers, what you need is a party on the other end who’s willing to buy the exact same number of shares, at the same time. And even then, there’s the problem of negotiation – you’ll need to find a middle ground between what you’re asking for and what the person is willing to pay for it.

Making the market – Standing ready to buy or sell a given stock at every second of the trading day at the market price. Hence a Market Maker is a party (which can either be an individual or a member firm of exchange) that buys and sells securities at any given point of the trading hour. They’re basically like whole sellers in the financial market.

The play of Market maker increases liquidity in the market. Take the case of forex pricing, where currency pairs are measured in the order of 1/1000 decimal places, and you require a lot of capital to earn profits. A standard lot may also be unaffordable for many traders. Market makers in this case fraction the positions they take from major banks and allow individual traders to get access to forex trading.

Book your CFA/FRM Demo Session Click Here

So, what’s in it for them?

The strategy is that Market makers usually charge higher ask price (price at which one sells), and offering lower bid price (price at which one buys). This difference between the bid price and ask price is called the bid-ask spread, and this is where the market maker earns from.

For example, a market maker may purchase 10 shares of IBM for $100 each and may sell the shares at $100.05 each, thereby earning a profit of $0.05 from each share bought and sold.

No profit is without any risk. In the above example, a market maker can face a decline in the value of security after it has been purchased and before a seller is found. In markets that are very illiquid, Market makers can get stuck in wrong positions as the difference between getting into a position and exiting the position may be big and end up being unfavorable.

Today, the majority of the market making is done algorithmically since they provide a number of benefits over their human counterpart. To be efficient as a market maker, you need to adjust your quotations immediately as per the market events, but there’s a limitation so as to how fast a human can work. Additionally, usage of automated systems for market-making provides for scalability, 24×7 availability, and faster response time.

Book your CFA/FRM Demo Session Click Here

In a Nutshell:

A market maker is someone who stands ready to buy or sell any asset at any trading time at a market price. He takes risks and earns profits on the basis of the bid-ask spread.

About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.

Related Post:

What is Naked Short Selling

Market Order vs Limit Order

Related Posts

Leave a Reply

Your email address will not be published. Required fields are marked *

three × three =