Market makers have an infamous reputation for being an institution that manipulates traders' orders. Little did we know, they're just another market player with distinct thinking and purposes.

So you've done your homework, signed into the trading site, set up that deal... and clicked the order button. A fraction of a second later, you're filled—at your price, with a penny-wide bid/ask spread.

That was simple. Perhaps too simple? After all, you know what they say about a contract that was reached too quickly.

Not to worry; this is intentional. It contributes to current capital markets being liquid, tight, and active. The market maker is at the center of it all.

 

What is Market Maker?

A market maker is a company or individual who actively quotes two-sided markets in certain securities, delivering bids and offers (known as asks) as well as the market size of each. Market makers give liquidity and depth to markets while profiting from the bid-ask spread discrepancy. They may also conduct major trades for their accounts.

What market makers do behind you?

Many exchanges have a system of market makers, with each trying to establish the highest bid or offer to earn the business of incoming orders. However, some, such as the New York Stock Exchange (NYSE), use a specialized system instead. The specialists are essentially lone (and designated) market makers who have a monopoly on order flow in a certain security or securities. Because the NYSE is an auction market, investors compete to forward bids and requests.

Market makers are also quite different from brokers. A broker makes money by bringing together assets to buyers and sellers. On the other hand, a market maker helps create a market for investors to buy or sell securities. Brokers are intermediaries who have the authorization and expertise to buy securities on an investor's behalf. There are full-service and discount brokers depending on the level of service a client needs. Market makers are typically large banks or financial institutions. Market makers help to ensure there's enough volume of trading so trades can be done seamlessly.

 

What Does a Market Maker Do?

At any given time, there might be any number of other market players buying and selling, including traders and investors like you, as well as money managers, institutional investors, and hedge funds.

You may be purchasing shares. You might also buy a fund and have the fund managers invest in the shares. A professional money manager, on the other hand, may sell that stock to rebalance a portfolio or as part of a long/short relative value transaction. A retiree may sell a few shares each month to cover living expenses.

And while any of these participants may be inclined to sell to you, it is doubtful they will do so at your specific price and amount. This is when the market maker enters the picture.

Market makers do not have all-powerful wands. They're just doing their duties as intermediaries—professional traders who are compensated to take a risk and offer market liquidity to make it simpler for retail and institutional traders to join and exit deals. Market creators, in a nutshell, bridge the gap between natural customers and natural suppliers.

 

Models, Algorithms, Arbitrage

Where do market makers submit their bids and offers? To respond, it is necessary to first comprehend the idea of arbitrage. Arbitrage is defined as the quick buying and selling of the same (or comparable) items across markets to capture and close price inefficiencies.

Consider that there are dozens, if not hundreds, of market makers competing at any given time. It's simple to understand why today's markets are usually tight, deep, and liquid. Here are a few examples of arbitrage employed by market makers to keep prices stable:

  • Index arbitrage — The purchasing and selling of stocks versus an index, such as the S&P 500 to maintain their values stable.
  • Fixed-income arbitrage — Market makers and dealers who purchase and sell bonds with varying degrees of risk profiles to keep interest rates stable (adjusted for relative risk profiles).
  • Volatility arbitrage — Option market participants use theoretical options pricing models to determine the relative value (and implied volatility levels) of options across strike prices and expiration dates.

A large trade in strike prices might influence the market. To manage the risks, market makers running volatility arbitrage algorithms might spread their risk from this transaction among other strikes, related products, and shares of the underlying company. These and other hedging deals can serve to mitigate the impact of a single large order and keep prices stable.

 

It's All About Math

Everything boils down to market maker methods and techniques, and how they differ from those of retail traders. At its most basic, both seek to maximize returns while controlling risks. They may approach things differently. Option market makers, for example, utilize theoretical pricing models to predict probabilities given particular inputs, including expiration dates, underlying price, interest rates, and volatility indices, to establish the theoretical value of an option.

Over time, a market maker who can purchase below and sell above theoretical value might profit. An options market maker who may be trading hundreds or even thousands of various strikes in several stocks at any same time isn't concerned with individual deals, but rather with the mathematical advantage that market makers referred to as "edge". If they can continuously accumulate an edge from individual deals, they can "actualize the theoretical" over time and with careful risk management.

 

Inventory Risk Management

When market makers manage positions, it's not all that different from any business owner storing stockpiles of a product. Think of a farmer who has a lot of corn to sell. Farmers don't know exactly where the price will be when it's time to sell, but they can hedge that risk using another type of derivative—futures contracts that lock in a sales price.

Market makers don't know the price of anything in the future, either. But they use trade data from across markets to help set fair prices for where they would be willing to buy or sell at any given point in time. And in the process of making markets and taking the other side of order flow, they accumulate inventory. They often use stock, options, futures contracts, or other derivatives to help them manage risk.

In the end, the person on the other end of your order does not know everything. Market makers are just expert traders who may consider their positions differently than ordinary traders or investors.