What Are Market Makers and How Do They Make Money?
Understand this key part of stock trading
The speed and simplicity with which stocks are bought and sold can be taken for granted, especially in the era of app investing. It takes just a few taps to place an order with your brokerage firm, and depending on the type of order, it can be executed within seconds. A behind-the-scenes force helping these transactions execute so quickly is known as the market maker.
Whenever an investment is bought or sold, there must be someone on the other end of the transaction. If you want to buy 100 shares of Disney, for example, you must find someone who wants to sell 100 shares of Disney. However, it's unlikely that you will immediately find someone who wants to sell the exact number of shares you want to buy. This is where market makers come in.
What Market Makers Do
Market makers—usually banks or brokerage companies—literally "make a market" for a stock by standing ready to buy or sell a given stock at every second of the trading day at the market price. This is good for traders because it allows them to execute trades whenever they want, more or less. When you place a market order to sell your 100 shares of Disney, a market maker will purchase the stock from you, even if it doesn't have a seller lined up. The opposite is true, as well, because any shares the market maker can't immediately sell will help fulfill sell orders that come in later.
Without market makers, it would take considerably longer for buyers and sellers to be matched with one another. This would reduce liquidity, making it more difficult to enter or exit positions and adding to the costs and risks of trading. Financial markets need to operate smoothly because investors and traders prefer to buy and sell easily. Without market makers, it's unlikely that the market could sustain its current trading volume. This would reduce the amount of money available to companies, and in turn, their value.
Market makers are required to continually quote prices and volumes they are willing to buy and sell at. Generally, a market maker commits to buying and selling at least 100 shares at any given moment. Larger orders could be filled by multiple market makers.
Market demand dictates where market makers set their bid prices (what they're willing to pay for shares) and ask prices (how much they're demanding).
This process helps to maintain consistency with markets. In times of volatility, the relatively stable demand of market makers keeps the buying and selling process moving. Without them, buyers could find it difficult to get in on a hot stock, or sellers could find themselves unable to sell a stock that's tanking.
How Market Makers Earn Money
When an entity is willing to buy or sell shares at any time, it adds a lot of risk to that institution's operations. For example, a market maker could buy your shares of common stock in IBM just before IBM's stock price begins to fall. The market maker could fail to find a willing buyer, and therefore, they would take a loss. That's why market makers want compensation for creating markets. They earn their compensation by maintaining a spread on each stock they cover.
For example, let's look at the hypothetical trade of IBM shares. A market maker may be willing to purchase your shares of IBM from you for $100 each—this is the bid price. The market maker may then decide to impose a $0.05 spread and sell them at $100.05—this is the ask price. The difference between the ask and bid price is only $0.05, but the 90-day average trading volume for IBM is more than 4 million. If a single market maker covered all those trades and made $0.05 off each one, they'd earn more than $200,000 every day.
Office of Investor Education and Advocacy. "Market Makers." Accessed Feb. 10, 2020.
Office of Investor Education and Advocacy. "What Is Risk?" Accessed Feb. 10, 2020.
Office of Investor Education and Advocacy. "Liquidity (Or Marketability)." Accessed Feb. 10, 2020.
Office of Investor Education and Advocacy. "Market Capitalization." Accessed Feb. 10, 2020.
Securities and Exchange Commission. "Market Maker." Accessed Feb. 10, 2020.
Securities and Exchange Commission. "Trade Execution." Accessed Feb. 10, 2020.
Office of Investor Education and Advocacy. "Bid Price." Accessed Feb. 10, 2020.
Office of Investor Education and Advocacy. "Ask Price." Accessed Feb. 10, 2020.
Nasdaq. "International Business Machines Corporation Common Stock." Accessed Feb. 10, 2020.