Every time you buy or sell a stock, someone is on the other side of that trade. But who is willing to trade with you at any moment? Often, it is a market maker. These financial firms play a crucial role in keeping markets functioning smoothly, yet most retail traders do not fully understand what they do.
What is a Market Maker?
A market maker is a firm or individual that stands ready to buy and sell a particular security at publicly quoted prices. They provide liquidity by always offering to buy from sellers and sell to buyers, even when there might not be another trader on the opposite side.
Think of it like a currency exchange booth: When you travel abroad, the booth is always willing to buy your dollars or sell you euros. They make money on the spread between their buy and sell prices. Market makers work similarly but with stocks, options, and other securities.
How Market Makers Work
Market makers continuously post two-sided quotes showing the prices at which they will buy and sell a security:
- Bid price: The price at which they will buy from you
- Ask price: The price at which they will sell to you
- Spread: The difference between bid and ask is their potential profit
When you place a market order to buy, you typically pay the ask price. When you sell, you receive the bid price. The market maker pockets the difference.
Example: Market Maker Quote
A market maker posts a quote for XYZ stock:
- Bid: $50.00 (will buy at this price)
- Ask: $50.02 (will sell at this price)
- Spread: $0.02
If you buy 1,000 shares at $50.02 and someone else sells 1,000 shares at $50.00, the market maker earns $20 on those transactions (1,000 x $0.02).
Why Markets Need Market Makers
1. Continuous Liquidity
Without market makers, you might place an order and wait hours or days for someone willing to trade at your price. Market makers ensure there is always a counterparty available, enabling instant execution.
2. Tighter Spreads
Competition among market makers narrows the bid-ask spread. Tighter spreads mean lower trading costs for everyone. In highly liquid stocks, spreads can be as small as one cent.
3. Price Stability
Market makers help absorb temporary imbalances between buyers and sellers. If there is a surge of sell orders, the market maker buys, preventing the price from crashing. They then gradually sell those shares back to the market.
4. Price Discovery
By constantly updating their quotes based on supply and demand, market makers help establish fair prices for securities. Their quotes reflect the current market consensus on value.
Types of Market Makers
Designated Market Makers (DMMs)
On the New York Stock Exchange, certain firms are assigned as the official market maker for specific stocks. They have special obligations to maintain fair and orderly markets in their assigned securities.
Wholesale Market Makers
These firms execute retail order flow, often purchasing orders from brokerages. Citadel Securities and Virtu Financial are major wholesale market makers that handle a large percentage of retail stock trades.
Electronic Market Makers
Algorithmic trading firms that provide liquidity across multiple venues simultaneously. They use sophisticated technology to quote prices and manage risk in real-time.
Options Market Makers
Specialists who provide liquidity in options markets. They must quote prices for thousands of different strike prices and expirations, making options market making particularly complex.
How Market Makers Profit
Earning the Spread
The primary profit source is capturing the bid-ask spread. By buying at the bid and selling at the ask, market makers earn the difference on each round trip.
Payment for Order Flow
Wholesale market makers pay brokerages for the right to execute their customers' orders. They can profit from this arrangement because retail order flow is often less informed than institutional flow.
Rebates and Incentives
Exchanges pay rebates to market makers who add liquidity to the order book. These rebates encourage tighter spreads and deeper liquidity.
Market Maker Risks
Market making is not risk-free. These firms face several challenges:
- Inventory risk: Holding securities that might decline in value
- Adverse selection: Trading against informed traders who have better information
- Volatility spikes: Rapid price movements can cause significant losses
- Technology failures: System outages can be extremely costly
During the 2010 Flash Crash, market makers faced massive losses as prices plunged and rebounded within minutes. Many pulled their quotes, which worsened the situation.
What This Means for Retail Traders
Your Orders May Go to Market Makers
When you place an order through a commission-free broker, it is likely routed to a wholesale market maker like Citadel Securities or Virtu. They execute your order and pay your broker for the privilege.
You Benefit from Their Competition
Competition among market makers results in tight spreads. In major stocks like Apple or Microsoft, the spread is often just one cent, saving you money on every trade.
Liquidity is Not Guaranteed
During extreme market stress, market makers may widen spreads or reduce the size of their quotes. This is when liquidity can evaporate precisely when you need it most.
Market Makers vs. Specialists
The traditional NYSE specialist system has largely been replaced by designated market makers. The key differences:
- Specialists: Had exclusive privileges but also strict obligations for assigned stocks
- DMMs: Still have obligations but face more competition from electronic traders
- Electronic markets: Multiple market makers compete simultaneously
Common Misconceptions
Market makers do not manipulate prices
While some believe market makers move prices against retail traders, they primarily profit from the spread, not directional bets. Manipulating prices would expose them to regulatory action and trading losses.
They are not trading against you
Market makers are typically market-neutral, meaning they hedge their positions to avoid directional exposure. They want to earn the spread, not bet on which way a stock will move.
Understand Your Order Execution
Pro Trader Dashboard shows you exactly how your orders are executed and helps you track spreads and slippage across all your trades.
Summary
Market makers are essential participants that provide liquidity to financial markets. They stand ready to buy and sell securities, earning profits from the bid-ask spread. For retail traders, market makers enable instant order execution and tight spreads in liquid securities.
Understanding how market makers operate helps you appreciate why spreads vary between securities and why liquidity can disappear during market stress. Learn more about related concepts in our guides on bid-ask spreads and order books.