Market Maker Explained: How They Make Money & Example
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Summary:
Market makers are an essential part of the financial markets. They are firms or individuals that provide liquidity to the market by continuously buying and selling securities. In return, they earn profits from the bid-ask spread, the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. Market makers play a crucial role in maintaining an orderly market and ensuring that buyers and sellers can trade at any time.
Overview of market makers
Market makers are financial firms that are responsible for maintaining liquidity in the stock market by buying and selling shares of various stocks. They play an important role in ensuring that there are always willing buyers and sellers for a given stock.
Market makers are typically appointed by stock exchanges and are required to meet certain regulatory requirements. In the United States, the Securities and Exchange Commission (SEC) sets rules and regulations for market makers.
How market makers make money
Market makers generate profits by buying shares at the bid price and selling them at the ask price. The bid price is the highest price that a buyer is willing to pay for a stock, while the ask price is the lowest price that a seller is willing to accept for a stock. The difference between these two prices is known as the spread, and market makers make money by buying at the bid price and selling at the ask price.
Market makers also earn profits by providing liquidity to the market. They do this by maintaining an inventory of stocks that they are willing to buy or sell. When there are more sellers than buyers, market makers buy shares and add them to their inventory. When there are more buyers than sellers, market makers sell shares from their inventory.
Good To Know: Market makers help reduce the costs of trading, enhance market efficiency, and promote market stability
Market makers vs. DMMs
Market makers should not be confused with designated market makers (DMMs). While both market makers and DMMs provide liquidity to the stock market, DMMs have additional responsibilities. DMMs are responsible for maintaining an orderly market by making sure that there is a fair and orderly market for a specific set of stocks. DMMs are also responsible for managing price volatility by temporarily halting trading if necessary.
Market makers by exchange
Market makers operate in various exchanges globally, and each exchange has its own set of rules and regulations. Here are some of the most popular exchanges and the market makers that operate on them:
- New York Stock Exchange (NYSE): The NYSE is the world’s largest stock exchange and is home to market makers such as Citadel Securities, Jane Street, and IMC Trading.
- Nasdaq: Nasdaq is a global electronic marketplace for buying and selling securities, and its market makers include Susquehanna, Citadel Securities, and Jane Street.
- London Stock Exchange (LSE): The LSE is one of the oldest and largest stock exchanges in the world, with market makers such as Optiver, Flow Traders, and DRW Trading.
- Tokyo Stock Exchange (TSE): The TSE is the largest stock exchange in Japan, and its market makers include Daiwa Securities, Nomura Securities, and Mizuho Securities.
- Hong Kong Stock Exchange (HKEX): The HKEX is a leading international stock exchange, with market makers such as Optiver, IMC Trading, and DRW Trading.
Each exchange has its own market structure, trading rules, and requirements for market makers. This means that market makers must adapt to each exchange’s unique environment to succeed.
Example
Let’s say that a trader wants to buy 100 shares of Apple (AAPL) at $150 per share. The market maker for AAPL sets a bid-ask spread of $149.95-$150.05. The trader can either accept the ask price of $150.05 or negotiate with the market maker for a better price. If the trader accepts the ask price, the market maker will sell the 100 shares to the trader and make a profit of $0.10 per share, or $10 in total.
The market maker earns this profit by buying the shares at a lower price from a seller and selling them at a higher price to the buyer. The market maker’s goal is to make a profit while also providing liquidity to the market.
Market maker FAQ
What is a market maker’s role in an initial public offering (IPO)?
Market makers play an important role in IPOs by ensuring that there is a market for the newly issued shares. They do this by agreeing to buy shares from the company at a set price and then selling those shares to investors.
Do market makers always make a profit?
No, market makers do not always make a profit. They take on the risk of holding inventory, and if the price of a stock moves against them, they can incur losses.
Can individual investors become market makers?
In general, no. Market making requires significant financial resources and regulatory approvals. It is typically done by large financial firms.
Key takeaways
- Market makers are financial firms responsible for maintaining liquidity in the stock market by buying and selling shares of various stocks.
- Market makers make money by buying shares at the bid price and selling them at the ask price.
- Market makers also earn profits by providing liquidity to the market.
- Market makers should not be confused with designated market makers (DMMs), who have additional responsibilities.
- Different stock exchanges have different market makers.
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