Electronic Trading: The Role of a Market Maker

Market makers compete for customer order flows by displaying buy and sell quotations for a guaranteed number of shares. The difference between the price at which a market maker is willing to buy a security and the price at which the firm is willing to sell it is called the market maker spread. Because each market maker can either buy or sell a stock at any given time, the spread represents the market maker's profit on each trade. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order. There can be anywhere from four to 40 (or more) market makers for a particular stock depending on the average daily volume. The market makers play an important role in the secondary market as catalysts, particularly for enhancing stock liquidity and, therefore, for promoting long-term growth in the market.

Market makers must maintain continuous two-sided quotes (bid and ask) within a predefined spread. A market is created when the designated market maker quotes bids and offers over a period of time. They ensure there is a buyer for every sell order and a seller for every buy order at any time.

Once the market maker has entered a price, he or she is obligated to either buy or sell at least 1,000 securities at that advertised price. Once the market maker has either bought or sold these shares, he or she may then "leave the market" and enter a new bid or ask price to make a profit on the previous trade.

For example, let's say that a market maker has entered a sell order for Microsoft (MSFT) and the bid/ask is $65.25/$65.30. The market maker can try to sell shares of MSFT at $65.30. If this is what the market maker chooses to do, he or she can then turn around and enter a bid order to buy shares in MSFT. The market maker can bid higher or lower than the current bid of $65.25. If he or she enters a bid at $65.26 then a new market is created (referred to as making a market) because that bid price is now the best bid. If the market maker attracts a seller at the new bid price of $65.26 then he or she has successfully "made the spread." The market maker sold 1,000 shares at $65.30 and bought these shares back at $65.26. As a result, the market maker made $40 (1,000 shares x $0.04) on the difference between the two transactions. This might not seem like much, but doing this repeatedly with larger order sizes can provide lucrative profits. All day long market makers do this, providing liquidity to individual and institutional investors. The major risk for the market maker is the time lapse between the two transactions; the faster he or she can make the spread the more money the market maker has the potential to make.

However, making money from the differences in bid and ask prices is not the only function of market makers. Their first priority is to provide liquidity to their own firm's clients, for which they will receive a commission. They may also facilitate trading for other brokerage firms, which is very similar to the duties of a specialist.

It should also be noted that market makers are required by law to give customers the best bid or ask price for each market order transaction. This ensures a fair and reasonable two-sided market. If these regulations were not in place, customers' profits would be gouged and share prices would be much more volatile than they already are.