The US Securities and Exchange Commission defines a market maker as “a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price.” Put simply, they serve as the in-between in a transaction. Let’s put this into an example so their role can be better understood.
Let’s say you want to buy 1,000 shares of Facebook. In order to do that, you need a willing seller. It’s not everyday that you’ll find someone with the same interests as you at that particular moment. Then again, as online trading goes, you do get the transaction made. How did that ever happen? Well, that is where the market maker comes in.
The Role of a Market Maker
In general, a market maker should be “ready to buy and sell at least 100 shares of a stock they make a market in,” according to the US Securities and Exchange Commission. Because this is the case, several market makers work together, each with different prices, when an investor puts in a very large order.
Each market maker displays both buy and sell quotations for a number of shares – which are guaranteed – in order to compete for customer order flow. A market maker then sells from their own inventory or looks for an offsetting order when an order is received. This process happens in a matter of seconds.
Nasdaq is a perfect example of how market makers operate. More than 500 member firms act as market makers thus ensuring the financial markets are always in motion.
How Market Makers Work
As mentioned earlier, market makers put up buy and sell prices for a guaranteed number of shares in order to compete for customer order flows. Essentially, they are taking risks and they make up for it through what’s called the market maker spread. This is basically the price difference between what a market maker is willing to buy a stock for and what the firm is willing to sell.
For example, a market maker purchases Facebook shares for $100 (the ask price). They can offer this to a buyer for $100.05 (the bid price). The difference – $.05 – is the market maker spread. That’s quite a small amount but also take note that millions of shares are traded each day. Put simply, the spread represents the profit a market maker made for each trade.
When a market maker receives an order, they sell from their own inventory or search for an offsetting order. As little as four or as many as 40 – even more – market makers can be working in a particular stock. How many exactly depends on the average daily volume for that stock.
Market makers also function as catalysts in the secondary market because they improve stock liquidity, and as a result, drive long-term growth in the market.
A market maker should always maintain a bid and ask price for a predefined spread. It’s when a designated market maker quotes bids and offers over a period that a market is created. Basically, the role of a market maker is to make sure there is a buyer for every sell order, as well as a seller for every buy order.
After a market maker has entered a price, they can either buy or sell at least 1,000 shares with the price that was advertised. When a market maker has bought or sold shares, they can “leave the market” and enter a new two-sided quote so they can make a profit on the previous trade.