A market maker is a company or individual willing to buy or sell a security. Investors may take the ability to buy and sell securities whenever they want for granted. Remember that every time you buy or sell an investment, there is another party on the other end of that trade. This party is often a market maker.
The market maker will provide updated prices at which it wants to buy or sell and the amounts of securities it wants to buy or sell at these prices. Let’s dive into how market makers operate, why they are important to the stock market, and how they make money.
Understand market makers
Market makers are usually banks or brokerage firms that provide trading services. By creating a stock market, these banks and brokerages allow much more business and use of their services.
Market makers usually hold stock for any securities in which they establish a market. In addition, they are constantly offering quotes that they are willing to pay to buy more shares (the bid price) and the price they are willing to sell. Share for (ask price). The difference between the buy and sell prices is called the bid and ask price difference.
When a market maker receives a buy order, it will immediately sell shares of its stock at the specified price to fulfill the order. If he receives a sell order, he buys the shares at his stated price and adds them to his stock. It will take either side of the trade, even if there is no other side lined up right away to complete the trade.
Market makers are regulated by the exchange they operate on, as well as any financial industry regulators in the country in which they reside since they act as brokers and dealers. Stock exchanges in the US are regulated by the US Securities and Exchange Commission (SEC). Brokers and traders must also register with FINRA.
Market makers in different markets and those operating on different exchanges are subject to different rules regarding what they are allowed to buy and sell and the types of deals they can make.
How do market makers improve the market
The main function of a market maker is to reduce volatility and facilitate price discovery in the stock market by providing a limited trading range for the security in which they are making the market. The market maker allows the free flow of transactions because it will take the other side of the trade even when no buyer or seller is lined up to complete the transaction immediately.
If market makers are not present, each buyer will have to wait for the seller to match his orders. This can take a long time, especially if the buyer or seller is not willing to accept partial filling of his order. (i.e. they either take the full number of shares they requested or they take none). Without market makers, most securities are not likely to have enough liquidity to support today’s trading volume.
How do market makers make money?
The market maker makes two offers: one is the price at which he is willing to buy the security, and the other is the price at which he is willing to sell. The market maker’s selling price is always higher than the purchase price, usually by just a few cents. As noted earlier, the difference between the buying and selling price is called the bid and ask price difference.
Market makers make money from bid and ask spreads because they are dealing with a large volume. Therefore, if the market maker buys shares on average a few pennies less than he sells them, with sufficient volume it generates a large amount of income.
For example, if An apple (NASDAQ: AAPL) Trading around $175 per share, the market maker might offer a bid (the price at which they are willing to buy) $174.95 and an ask price (the price they are willing to sell) $175.05. The difference of $0.10 may not seem like much to retail investors, but keep in mind that 90 million shares of Apple stock trade daily. If every Apple stock trade went through a market maker, that would add up to $9 million in their pockets every day.
However, the market maker bears some risks. There is no guarantee that he will be able to find a buyer or seller at the given price. He may see more sellers than buyers, causing his stock to rise and his prices to fall, or vice versa. And if the market moves against it, and does not set enough spread between supply and demand, he may lose money.
The importance of market makers
Market makers are necessary to enable financial markets to function smoothly and to meet market demands large and small. Anytime you invest in stocks, there is someone at the other end of your trade, and it could be a market maker.