A Resource for Introductory Market Making and Market Microstructure Theory
What Is A Market Maker?
A market maker is an intermediary who facilitates the buying and selling of a security by quoting the prices and volumes at which they are willing to buy and sell this security at.
Canal in Amsterdam, Claude Oscar Monet (1874)
A market maker is one who makes markets.
To me, the more important question lies in understanding what it means to “make a market”, or even further, “what is a market?”. A market is a place where goods are bought and sold. To “make a market” means to provide the prices at which you are willing to buy and sell said goods at. Thus, market-makers are people who make markets by setting these prices. The concept of market-making can be traced back to pre-modern era markets, where instead of company’s stocks - the goods would be things like food or materials!
A few years ago, I watched this video posted by Citadel Securities, one of the world’s largest market-maker, which to this day, I still find to be one of the clearest videos on what market-making is.
Quick recap, now speeding up to world of financial markets. A market maker is an intermediary who facilitates the buying and selling of a security by quoting prices, and volumes, at which they are willing to buy and sell this security at. This serves a convenient purpose of circumventing the issue of buyers having to find specific sellers, and vice-versa. Instead, transactions are centralized around market-makers. Sellers can quickly get rid of their inventory by selling it to the market makers, and similarly buyers can quickly purchase inventory.
The ability to buy and sell quickly is a cornerstone of modern markets, and is deeply tied to the concept of liquidity. More on this in the next article! Now, while market-makers playing a vital role in make markets more efficient, this “service” comes with risk for the market-maker, and thus they are compensated on taking this risk.
How do Market Makers Make Money?
When you google the price of your favorite stock or check your watchlist on Yahoo Finance, you are usually shown the Last price. The last price represents the latest transacted price. However, when you purchase this stock through your online brokerage account, it’s very likely that you won’t be paying the Last. You will pay what is know as the Ask. On the other hand, if you were to sell or short a stock, you will receive the Bid.
A quick thought experiment: Setup:
- You are able to buy and sell stocks without transaction fees (fees for your online brokerage account).
- Orders will be filled immediately.
The current quote for stock XYZ is Last: $ 100.00 , Bid: $ 99.95 , Ask: $ 100.05
Now, you are going to buy stock XYZ, and immediately sell it. When you buy the stock, you pay the Ask. Now, upon immediately selling the stock, you receive the Bid. A quick P/L calc: $(100.05) + 99.95 = (0.10)$
For buying and selling stock XYZ near instantaneously, a seemingly harmless event where you start with zero position, and end with zero position, you have paid $ 0.10.
This is what is called the Spread, and it is one of the main ways in which market makers are compensated for facilitating the buying and selling of securities. More formally, the Spread is the defined as the difference between the Ask and the Bid. Since the Ask is normally higher than the Bid, the Spread is typically positive. As a quick rule of thumb for remembering which one you pay/receive when trading, you will always PAY (buy at) the higher price. So how do market makers make money off of the Spread? Specifically, the mechanics of our thought experiment are reversed for market makers, meaning that they receive the Ask and pay the Bid, resulting in a profit of $ 0.10 from doing the exact actions as above. Now, at first it seems like market-makers can NEVER lose money! However, there are a variety of risks that market makers take on for doing this. Further, it’s important to understand HOW market makers are able to receive this spread, and how this spread is created in the first place.
Now that we have a base understanding of what a market maker is and how they make money, we need to understand more about the mechanics of the markets we operate in. There are a lot of thought avenues to embark on next, but I believe the most sensible next step is to dissect what is known as liquidity, as this concept captures MUCH of what drives markets and the field of market making.