What Is a Market Maker?
The term “market maker” refers to a firm or individual who actively quotes both sides of a market in a particular security by providing bids and offers (known as asks) along with the market size of each. In fact, they are obligated to engage in such trading activity.
Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread. They may also trade for their own accounts. Such trades are known as principal trades.
Understanding Market Makers
Many market makers are brokerage houses that provide trading services for investors. They make markets in an effort to keep financial markets liquid.
A market maker can also be an individual trader, who is commonly known as a local. The vast majority of such market makers work on behalf of large institutions due to the lot sizes needed to facilitate the volume of purchases and sales.
Important
Market makers facilitate a smooth flow of market activity by making it easier for investors and traders to buy and sell. Without market makers, there could be insufficient transactions and fewer opportunities to invest efficiently.
How They Work
Each market maker displays buy and sell quotations (two-sided markets) for a guaranteed number of shares. Once the market maker receives an order from a buyer, they immediately sell their position of shares from their own inventory. This allows them to complete the order.
A market maker must commit to continuously quoting prices at which it will buy (or bid for) and sell (or ask for) securities.
Market makers must also quote the volume in which they’re willing to trade along with the frequency of time they will quote at the best bid and best offer prices.
Market makers must stick to these parameters at all times, no matter what their market outlook. When markets become erratic or volatile, market makers must remain disciplined in order to continue facilitating smooth transactions.
Example of a Market Maker
Let’s say there’s a market maker in XYZ stock. They may provide a quote of 10.05 or 100 x 500. This means that they bid (they will buy) 100 shares at 10.05. Other market participants may then buy (lift the offer) from the market maker at 10.00.