Who and what are the market makers
If you have traded in a standardized security market, you may have noticed that except for a few illiquid securities, your orders are executed pretty fast. There is almost always a bid or ask price available. You just have to type in an order and your order is matched with an opposite order almost immediately.
Market makers play a major role in ensuring the liquidity of securities and smoother transactions.
Please do no get confused with security exchanges and market makers. Security exchanges are exactly what their name suggests. They ensure a platform or a place where the securities can be exchanged. These days most of the securities are in the de materialized form. The exchanges ensure, the various transactions of all the securities registered with it or are open to trade in it.
So what are Market makers. Market Makers are also essentially participants in the security exchanges, just like investors and traders of securities. A market maker is a broker or a dealer firm which assumes the risk of holding a certain amount of a security, in order to smoothly expedite the trading in that security. Essentially they build up a large inventory of a security, so that when the buyers and sellers comes calling for that particular security, it is is available for easy trading. They buy up all the securities that the sellers have and re sells it to all the incoming buyers and vice versa. They display bid and ask quotations for the securities they hold, for a guaranteed number of securities.
Suppose a seller puts up a security for sale, the market maker buys it up immediately and seeks an opposite order. If a buyer puts an order, they immediately sell the security to the buyer. There is almost always an inventory with the market maker for all the securities traded in an exchange. If the market maker does not have the essential inventory of a security, either due to low float or low volume of trades, orders are matched between available buyers and sellers. If the bid and ask price of a buyer and seller is matched, then a trade happens. The market makers competes for customer orders by displaying bid and ask quotes for the securities they deal in.
Since the market makers need to facilitate large amounts of orders, in order to satisfy the supply and demand in the market, they take the opposite side of the trading volume, essentially buying and selling what the traders have put up in the market. In between they maintain a healthy inventory of the securities too. All these helps executing the trades very fast.
Different types of Market Makers
Market makers comes in all shapes and sizes. Most common type are the brokerage firms who offer various solutions for their clients, to facilitate trading in securities. In certain over the counter securities like bespoke forward contracts, there may be individual intermediaries, who act as market makers, but by and large, market makers are established firms.
How do they function and profit
Before we try to understand what the market makers do, let us ponder over what the price of a security or for that matter price of anything in a market means.
Bid, Ask and Last Traded Price
If you have been looking around for purchasing a real estate property, the first thing you would have asked about is the price. You would inquire about the price at which the last transaction took place, you also would check what is the asking price of the owner, latest bids on the property and would form an opinion on what you would bid. So the price of that property can be the last traded price, the asking price, asking price for similar properties, or bid price.
For a traded security in an organised exchange, the price displayed, is the last traded price. It is the price at which the security last changed hands. But if you are more keen, you can also find out the bids and asks,the last traded volume, the over all trade volume, the bid and ask volume, open position volume in case of futures and options, and various other price parameters. And then place an order.
Limit Order and Market Order
The limit order and the market order are the two basic orders a trader/ investor can put forward with the intention of buying or selling a security.
If you put a buy or sell order such that you give instruction to buy or sell a security, only for a certain specific price, irrespective of the prevailing LTP, Bid or Ask price, then its a limit order. If the ask price comes down to your buy limit order, your trade gets executed and you get the security depending on the number of securities available for sale at that price. If the bid price rises up to your sell limit order, your order gets executed and you can sell your security depending on the number of bids available for your security at that price.
If you put a buy or sell order such that you give instruction to buy or sell a security, for the nearest available price, irrespective of the prevailing LTP, Bid or Ask price, then its a market order. If its a buy market order, the trading system will match your order to the nearest ask price and the trade is executed. The same goes for a sell market order.
Profit for Market Makers
Now let us address the question of how the market makers profits. You know that they display bid and ask quotes for each and every security they deal with. But they keep a spread between the bid and ask price. For example if the Last Traded Price at a point of time for a security is $10. They would put up a bid price of $9.95 and $10.05. The difference of $0.1 is called the spread. when sellers match their order for the bid price of $9.95, the market maker buys the security for $9.95 and almost immediately sells it to the buyers who have put up order for $10.05 and vice versa. They pocket the $0.1 profit. Since they deal in extreme large quantities, they make good profit.
Two common confusions
What happens if a buyer puts up an order for $10 or a seller puts up an order for $10 using a limit order, when the prevailing bid ask is $9.95 and $10.05 respectively?
Normally a market maker do not allow orders in between the bid ask prices., even if it's a limit order. As I mentioned before if the security is illiquid due to low float or trading volume, and the inventory of the market maker gets depleted, sometimes the system allows an in between order, and if an opposite in between order is available, they are matched and the orders are executed.
What happens to the large inventory of a market maker when the market falls sharply, won't they incur a loss?
When the market nosedives sharply,the market makers increases the spread exponentially. This allows them to make up for the losses on their large inventory.
Since the market makers need to facilitate large amounts of orders, in order to satisfy the supply and demand in the market, they take the opposite side of the trading volume, essentially buying and selling what the traders have put up in the market. In between they maintain a healthy inventory of the securities too. All these helps executing the trades very fast.
Different types of Market Makers
Market makers comes in all shapes and sizes. Most common type are the brokerage firms who offer various solutions for their clients, to facilitate trading in securities. In certain over the counter securities like bespoke forward contracts, there may be individual intermediaries, who act as market makers, but by and large, market makers are established firms.
How do they function and profit
Before we try to understand what the market makers do, let us ponder over what the price of a security or for that matter price of anything in a market means.
Bid, Ask and Last Traded Price
If you have been looking around for purchasing a real estate property, the first thing you would have asked about is the price. You would inquire about the price at which the last transaction took place, you also would check what is the asking price of the owner, latest bids on the property and would form an opinion on what you would bid. So the price of that property can be the last traded price, the asking price, asking price for similar properties, or bid price.
For a traded security in an organised exchange, the price displayed, is the last traded price. It is the price at which the security last changed hands. But if you are more keen, you can also find out the bids and asks,the last traded volume, the over all trade volume, the bid and ask volume, open position volume in case of futures and options, and various other price parameters. And then place an order.
Limit Order and Market Order
The limit order and the market order are the two basic orders a trader/ investor can put forward with the intention of buying or selling a security.
If you put a buy or sell order such that you give instruction to buy or sell a security, only for a certain specific price, irrespective of the prevailing LTP, Bid or Ask price, then its a limit order. If the ask price comes down to your buy limit order, your trade gets executed and you get the security depending on the number of securities available for sale at that price. If the bid price rises up to your sell limit order, your order gets executed and you can sell your security depending on the number of bids available for your security at that price.
If you put a buy or sell order such that you give instruction to buy or sell a security, for the nearest available price, irrespective of the prevailing LTP, Bid or Ask price, then its a market order. If its a buy market order, the trading system will match your order to the nearest ask price and the trade is executed. The same goes for a sell market order.
Profit for Market Makers
Now let us address the question of how the market makers profits. You know that they display bid and ask quotes for each and every security they deal with. But they keep a spread between the bid and ask price. For example if the Last Traded Price at a point of time for a security is $10. They would put up a bid price of $9.95 and $10.05. The difference of $0.1 is called the spread. when sellers match their order for the bid price of $9.95, the market maker buys the security for $9.95 and almost immediately sells it to the buyers who have put up order for $10.05 and vice versa. They pocket the $0.1 profit. Since they deal in extreme large quantities, they make good profit.
Two common confusions
What happens if a buyer puts up an order for $10 or a seller puts up an order for $10 using a limit order, when the prevailing bid ask is $9.95 and $10.05 respectively?
Normally a market maker do not allow orders in between the bid ask prices., even if it's a limit order. As I mentioned before if the security is illiquid due to low float or trading volume, and the inventory of the market maker gets depleted, sometimes the system allows an in between order, and if an opposite in between order is available, they are matched and the orders are executed.
What happens to the large inventory of a market maker when the market falls sharply, won't they incur a loss?
When the market nosedives sharply,the market makers increases the spread exponentially. This allows them to make up for the losses on their large inventory.
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