Every stock or security needs a market of buyers and sellers in order to move on the exchanges. Market makers are high-volume traders that literally "make a market" for securities by always standing at the ready to buy or sell. They profit on the bid-ask spread and they benefit the market by adding liquidity.
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. Without market makers, however, trading would slow down significantly.
What Is a 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.
Market makers—usually banks or brokerage companies—are always ready to buy or sell at least 100 shares of a given stock at every second of the trading day at the market price.
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), but market makers must always quote both prices for their trades.
How Market Makers Help the Market
This system of quoting bid and ask prices is good for traders because it allows them to execute trades more or less whenever they want. When you place a market order to sell your 100 shares of Disney, for example, 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 at which they are willing to buy and sell. Orders larger than 100 shares could be filled by multiple market makers. 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.
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, consider a 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 average daily trading volume for IBM is more than 6 million shares. If a single market maker covered all those trades and made $0.05 off each one, they'd earn more than $300,000 every day.
Market Maker vs. Specialist
A specialist is a type of market maker who operates on certain exchanges, including the New York Stock Exchange. Although their functions are similar, specialists have more duties in facilitating trades among brokers directly on the floor of an exchange. A specialist is one type of market maker who often focuses on trading specific stocks.
- Market makers encourage market liquidity by standing ready to buy and sell securities at any time of day.
- Without market makers, far fewer trades would happen and companies would have more limited access to capital.
- Market makers profit on the difference between the bid and ask prices on their trades.