The market maker spread is the difference between the price a market maker offers to buy a security for and the price they offer to sell it for. Generally, the market maker will buy securities for less than the current quote price and sell for more than the current quote price. The market maker can act as either the buyer or seller at any given time to create a market for securities, and the spread is part of their compensation for facilitating transactions.
Definition and Examples of the Market Maker Spread
To understand the market maker spread, it helps to first understand more how market makers work.
Buying and selling securities such as stocks may seem straightforward, but there’s a lot to it. If you want to buy stock, you need to find a seller, and vice versa. But it’s not always easy to find another party willing to transact with you at the exact moment you want to buy or sell. That’s where market makers come in.
Market makers are often financial institutions like banks that can afford to put up the capital needed to buy or sell securities at any time, thereby helping create a market for them. If you’re looking to buy shares of a particular company, you don’t have to find a specific person who owns that stock. A market maker often has those shares on hand and is willing to sell at any time. If you’re looking to sell shares, a market maker is often a willing buyer.
It’s not so much that a market maker wants to buy or sell stocks because they have a strong view on whether the price will go up or down. Instead, the market maker can profit off facilitating lots of transactions, due in part to the market maker spread, which is the gap between the buying and selling price.
- Alternate name: Bid-ask spread
The bid-ask spread refers to the difference between the bid and ask price that a market maker can set. The bid price refers to what the market maker will pay to purchase from you if you’re selling a stock. The ask price refers to what you will pay to purchase from the market maker if you’re buying a stock.
What does the market maker spread or bid-ask spread look like? Suppose there’s a $0.06 spread between the price a market maker will buy and sell a stock. A stock may be trading at $100, but if you want to sell the stock, the best price you may get is the market maker offer of $99.97. Then, a minute later, someone looking to buy the same stock might only be able to purchase it at the market maker’s price of $100.03.
That six-cent spread may not seem like much, but for the market maker who’s conducting large volumes of transactions, it can add up.
How Does the Market Maker Spread Work?
Have you ever bought or sold a stock and noticed that the final transaction price is slightly different than the current stock price? That can be due to the market maker spread.
The current stock price isn’t necessarily the same as what others are willing to buy or sell for. A market maker, in particular, needs to account for their risk of buying and selling stocks at any time.
So, the market maker spread or bid-ask spread enables the market maker to typically buy securities for slightly less than the current quote and sell for slightly more than the current quote to help them make a profit. In turn, investors gain the benefit of generally having buyers and sellers readily available.
Typically, securities with more trading activity (i.e., they are liquid) have tighter spreads, whereas ones that are traded infrequently (i.e., they are illiquid) have wider spreads. The tighter the spread, the closer you can get to the official market quote for the security.
If a stock is very popular and the current quote is $50, for instance, you might be able to sell it for $49.99. But if there’s very low trading activity for a more niche stock, perhaps you might only be able to sell a stock quoted at $50 for $49.50. That price difference (spread) helps the market maker account for the risk of not being able to find another buyer for the illiquid stock for a while.
Market makers don’t want to be left holding the bag as stock prices move since they’re not buying or selling to make a traditional investment. They’re buying and selling to make a market, which the spread helps account for.
What the Market Maker Spread Means for Individual Investors
Understanding the market maker spread can help you get a better price when buying or selling securities. If you just click buy or sell through your brokerage app, for instance, you might end up paying more for purchasing a stock than you expected. Or you might sell at a lower price than you anticipated. Instead, look at what your broker displays as the bid and ask price to see what you could currently buy or sell for.
If you’re not happy with the bid or ask price, one option is to set a limit price, if your broker enables this option.
Limit prices help you avoid bid or ask prices you don’t want to settle for. If you see that the bid price to sell a stock is $19.95 but you know you don’t want to sell for anything less than $20 per share, you could put in a limit order. Then the transaction will only go through if and when the price moves to $20. If the bid price remains below $20 for the duration you set the limit for, the transaction will not go through, and you can then decide whether to adjust your limit price or hold on to the stock.
You also might want to compare bid-ask prices among different brokerages. Some brokers may have policies or relationships that can help you access tighter market maker spreads. Buying or selling for a few pennies more or less may not seem like it matters at first glance, but the more shares you’re trading and the more you invest overall, the more that market maker spreads make a difference to your net return.
- Market maker spreads are the difference between the bid and ask price.
- Market maker spreads help compensate market makers for stepping in as buyers or sellers at essentially any time and assuming risk.
- Paying attention to the bid-ask spread can help investors get better pricing when buying or selling securities.