Market Makers Explained

Market makers are essential to functioning markets, providing liquidity and facilitating trades. Understanding their role helps you navigate order execution more effectively. [DEFINITION] Market Maker: A firm or individual that quotes both buy and sell prices for a security, profiting from the bid-ask spread while providing liquidity and facilitating orderly markets. ### What Market Makers Do **Provide liquidity:** - Always willing to buy or sell - Ensure you can trade when you want - Quote prices continuously **Maintain orderly markets:** - Prevent price jumps from lack of liquidity - Absorb temporary supply/demand imbalances - Narrow bid-ask spreads [KEY] Market makers make money from the spread (buying at bid, selling at ask) while taking the risk of holding inventory that might move against them. ### How Market Making Works [EXAMPLE] Stock XYZ: - Market maker quotes: Bid $49.95, Ask $50.05 - You sell 100 shares to market maker at $49.95 - Seconds later, buyer takes 100 shares at $50.05 - Market maker profit: $10 (100 × $0.10 spread) They do this thousands of times daily. ### Types of Market Makers **Designated Market Makers (DMMs):** - Assigned to specific stocks (NYSE) - Obligations to maintain fair and orderly markets - Step in during volatility **Competitive Market Makers:** - Multiple firms compete on NASDAQ - No single firm responsible - Competition narrows spreads **Electronic Market Makers:** - Algorithm-driven, high-speed - Provide most liquidity today - Citadel, Virtu, Two Sigma ### Market Maker Obligations **Must provide:** - Two-sided quotes (bid and ask) - Minimum quote sizes - Continuous presence during market hours **NYSE DMMs additionally:** - Step in during imbalances - Facilitate opening and closing auctions - Manage volatility [TIP] The presence of active market makers means you can typically trade immediately at quoted prices for normal order sizes. ### How Market Makers Affect You **Positive effects:** - Tighter spreads on liquid stocks - Faster execution - Ability to trade large stocks instantly **Potential concerns:** - Payment for order flow (broker sells your orders to market makers) - Possible front-running or information advantage - Less favorable execution for large orders ### Market Maker Behavior During Volatility When markets are volatile: - Market makers widen spreads (more risk) - May reduce quote sizes - Some may step back entirely - Liquidity decreases when you need it most [WARNING] During flash crashes or extreme volatility, market makers may withdraw, causing spreads to explode and prices to gap. ### Payment for Order Flow (PFOF) How it works: 1. You place order through retail broker 2. Broker routes to market maker (like Citadel) 3. Market maker pays broker for the order 4. Market maker executes your trade (and hopefully gives you price improvement) **Debate:** - Critics: Market makers profit from retail flow - Defenders: Retail gets commission-free trading and price improvement [EXERCISE] You place a market order to buy 100 shares of a stock quoted $50.00 bid, $50.05 ask. You're filled at $50.03. What happened? |ANSWER| You received "price improvement" of $0.02 per share from the market maker. Instead of paying the full ask ($50.05), the market maker executed inside the spread at $50.03. This is common with payment for order flow—the market maker still profits from the spread while giving you a better price than the displayed ask. ### Implications for Investors **For small orders:** Market makers typically provide good execution and price improvement. **For large orders:** - Your order may move the market - Consider limit orders and patience - Algorithm-based execution may help - Institutional-size orders require different strategies [SCENARIO] You want to sell 50,000 shares of a mid-cap stock. The bid shows 5,000 shares at current price with typical daily volume of 200,000 shares. How might market makers respond to your order? This is a significant order (25% of daily volume). Market makers may: 1) Lower their bids as you sell—your order signals supply. 2) Widen spreads to protect themselves. 3) Fill only partially and wait. Better approach: Break the order into smaller pieces, use limit orders, execute over time, or use a broker's algorithm designed for large orders. A market order would likely move the stock against you as market makers step back from providing full liquidity.