Honestly I think the hardest thing to date that is nearly impossible to find information on is how a market maker actually works. I've googled for hours before only to get very vague definitions, nothing concrete with actual examples/formulas.
Thank you, i will put "how market making works" on my list. Obviously that is a very detailed subject, but I think the basics can be covered pretty easily.
I agree, I'm sure it is wildly complicated, but something more than "market makers provide liquidity!!!" would do wonders. Something on par with the detail of your existing 2 posts would be 10/10...
Here's my understanding, starting with some background terminology:
Everything that's tradable on an exchange (an "instrument") has a bid/ask spread that represents the highest price someone's willing to pay to buy (the bid), and the lowest price that someone's willing to pay to sell (the ask). There is _always_ a bid/ask spread, because as soon as anyone places an order that would reduce the spread to zero, that means they're willing to pay what someone's asking, or vice-versa, and therefore the exchange immediately converts it into a trade--done deal!--and now there's a spread again. Incidentally, executing a trade this way is "crossing the spread", you're opting to "pay the difference" between the bid and ask to get your trade done.
Someone that crosses the spread is said to be "taking liquidity." They're willing to pay the surcharge of the bid/ask spread to get their trade executed right now. On the other hand, someone that sits at the bid/ask spread, waiting for someone to cross to execute, is said to be "offering liquidity," they're willing to patiently wait in order to save money equal to the spread.
Now, a market maker is a participant that is _solely_ interested in making money off that bid/ask spread, basically like a sports bookie. They're willing to always be in the market, on both sides, and take the spread whenever someone crosses over. So if say AMZN is trading at 3332.95 x 3333.05, they'll be offering to buy at 3332.95, and sell at 3333.05, and any time people take those offers, they make a dime. Do this thousands of times a day, on many different instruments, and you've got a business. That said, there's real risks in market making, and understanding them requires the idea of "informed" versus "uninformed" trading.
An uninformed trader comes to the market simply because they want to trade for some external goal unrelated to trading. Maybe they're selling stock for a house downpayment, or buying agricultural futures because they make potato chips and don't want to deal with the price shocks of a sudden drought. They're willing to cross the spread, and they don't particularly care if they lose a few pennies on the transaction, because that's not their goal. These traders are the meat and potatoes for market makers, because they don't move the fundamental price of the instrument, they're effectively noise. In a market of nothing but uninformed traders, you would expect your position as a market maker to fluctuate around zero, because you're buying roughly as much as you're selling.
An informed trader, on the other hand, "knows something". They're aware of some material fact (or at least a strong hypothesis) that indicates the price of the instrument is going to move dramatically in the near future. They're willing to cross the spread, because they know the spread is going to move with them anyway. These are danger for market makers, because they will all pile in on one side of the trade, all buying, or all selling, and now the market maker will end up in a losing position--short when the price is going up, or long when the price is going down.
Imagine running a Gamestop store: on a normal day, you might see half your customers buying a PS4 and half selling a PS4, but on the day that the PS5 is announced, suddenly everyone wants to sell their PS4 at the same time before you lower what you're offering.
The classic market maker algorithm looks at "inventory", basically your absolute outstanding position, and tries to keep inventory as low as possible. When uninformed trading is taking place, your inventory is around zero, and you can stay very close to the minimum spread. As your inventory grows, and you become either increasingly more long or short, you start pulling your bids or asks away from the best bid/ask to try and bias future trades back into a 50/50 ratio. All market makers doing this simultaneously means the bid/ask spread starts to widen as there's increased uncertainty about the price.
Another key element to market making comes down to trade volumes. You could, today, start market making, all you need to do is put in limit orders at the bid and ask and wait. However, you'd probably not make that much, because you're losing money to various trading commissions, exchange fees, roundtrip network latency, etc. Professional market makers make tens of thousands of automated trades in a day, and as a result, are able to negotiate substantially lower costs that make it worth doing. Many exchanges even have "designated market makers" that have special trading permissions in exchange for guaranteeing that they will _always_ provide some best bid/ask offer even in the worst case conditions, otherwise you in a sufficiently large event you could get a "liquidity crisis" (i.e. there's no one willing to buy or sell that instrument at any price).
That ended up being more text than I thought it would--apologies.
> Now, a market maker is a participant that is _solely_ interested in making money off that bid/ask spread, basically like a sports bookie. They're willing to always be in the market, on both sides, and take the spread whenever someone crosses over. So if say AMZN is trading at 3332.95 x 3333.05, they'll be offering to buy at 3332.95, and sell at 3333.05,
I guess my question is, how is that different, what they're doing, vs someone crossing over but the money goes directly to the other party? I notice you said the market maker is listing the same prices, I'm trying to visualize how their action is any different than the exact same spread/scenario but the buyer crosses over to the seller and the same trade happens. What is actually different?
> you start pulling your bids or asks away from the best bid/ask to try and bias future trades back into a 50/50 ratio
Also are you saying that the market maker dictates the bid ask spread and not the highest bidder/lowest seller
They are the other party--a market maker isn't (outside of the "designated market makers" I referenced earlier) a special participant in trading, they're just like you or me.
If I put a limit order in to buy at 3332.95, and someone takes it, I now have one stock. If I put in a limit order to sell at 3333.05, I sell that stock and make a dime. In aggregate, if I'm doing that many many times, and the price stays roughly around 3333, I'm making a dime on every round trip.
A "market maker" just means that I don't really care about investing or speculating, all I'm really in for is to collect that dime on the round-trip and sit at the bid/ask spread.
> Also are you saying that the market maker dictates the bid ask spread and not the highest bidder/lowest seller
No, as you've said, the highest bidder/lowest seller set the bid/ask spread. It's just, in any high volume market, chances are the incidental traders that want to improve the best offer clear very quickly--at any given point the market is probably going to clear until you hit the market makers. By definition, they're the folks willing to wait it out.
That said, market makers can compete with each other--if you are more ambitious than your competition, you might be willing to improve (narrow the spread) on your competitors. You'll make money by filling trades that they will miss out, but on the other hand, you're getting less spread and less profit per-trade. If that lower profit doesn't cover the statistical risk of losses from price movements, then you won't be profitable. The bid/ask spread narrows or widens based on the interactions of all market participants, just, if a particular instrument looks very risky, the market makers, acting as backstops, might want more money in the form of spread to warrant trading.
In practice, the most liquid instrument in the market these days trade pretty close to the minimum spread all of the time--high-frequency market makers are very efficient and so you rarely have to pay more than a penny to cross the spread. As a result, it's also not terribly profitable to make markets, since you're only earning a penny per round-trip for the risk you have to take.
(Compared to say, real estate, where the "bid/ask spread" is basically unknown and has to be discovered through the very expensive agent mechanism.)
Really detailed explanation! This is essentially it. While there's obviously a bunch more complexity, the essence of market making is just trying not to own a stock, but just buy and sell immediately.
Think about how when you go on holiday and want to change money. Admittedly it's becoming more online now, but when you go to a foreign exchange shop they will have a "we buy" and "we sell" price. They are essentially a market maker. They don't care about having a load of pounds, or dollars or rupees. They just want to buy low and sell high to you, and make the difference!
