how the basic mechanics of trading stocks work through prospective buyers and sellers offering their bid and ask prices and finding each other to execute trades. We also observed that this part of market mechanics, while essential, has also been made largely invisible to most investors. How has this piece of sausage making been so deftly concealed? Market makers.
Market makers provide an essential service: liquidity. A market that is “liquid” is one where there’s enough buying and selling going to make it easy to make a trade. If you’re buying, there are plenty of sellers at any given point to fill your need, and vice versa.
Market makers are usually a firm like a broker/dealer or an investment bank, but any company with cash in reserve and easy access to the markets can fill the role. The market maker is simply a firm that buys shares of that stock from anyone who’s selling them and then sell shares of that stock to anyone who’s buying.
On the surface, that doesn’t sound terribly important, but it’s actually really essential. Market makers create a single focal point for a stock that allows everyone to execute their desired trades without necessarily having to search around to find someone to take the other side of the transaction. They’re a conduit that facilitates quick, easy trading.
PURELY HYPOTHETICAL EXAMPLE #1
This might be easier to understand if we leave stocks behind for a minute. Say you’re a farmer who grows peppers and pickles them, one peck at a time. This year’s crop is ready to go, so you load up your 100 pecks of pickled peppers and head into town where the pickled pepper markets are located.
Unfortunately, once you get there, there aren’t any buyers looking for 100 pecks. In fact, no one is buying more than 10 pecks, and the buyers are spread out across the three different markets in town. You spend two full days traveling back and forth finding buyers to sell one or two pecks at a time. It’s inefficient and frustrating.
Then, just when you’re finally down to 5 pecks left to sell, a buyer shows up looking for 200. That buyer is now scrambling from market to market buying up pickled peppers one or two pecks at a time when, if they had arrived just two days earlier, you could have filled half their order right there, also saving yourself two days of furious deal making. This is not a liquid market, and it’s not good for anyone involved.
Let’s try this again with a market maker.
Peter Piper & Co. lets everyone know that they’re going to be a market maker for pickled peppers. Now, when you arrive in town, you just head straight to Peter Piper & Co. and sell all 100 pecks in one neat, clean transaction. So do all the rest of the pepper farmers. You’re headed back to your farm in no time flat.
Meanwhile, anyone looking to buy pickled peppers also heads straight to Peter Piper & Co. as that’s where the pickled peppers they need will be, be it one peck or a thousand. Just by creating a little slack in the supply, Peter Piper & Co. has allowed the pickled pepper market absorb the wildly inconsistent demand in stride. Everyone wins.
Profiting from the “Bid-Ask Spread”
Market makers for stocks do essentially the same thing as Peter Piper & Co., but at much faster speeds, owning stocks for mere fractions of a second. Even that fleeting moment between sellers selling and buyers buying, though, keeps things liquid and trading at a brisk pace.
“What a noble and selfless service these market markers provide!” Not exactly – they’re making money on the deal.
How? The “bid-ask spread.” Market makers will quote a price they will buy the stock at (their bid) and a price they will sell it at (their ask) with the ask being a little higher than the bid. That gap is what’s called the “spread.” It allows market makers to make money by selling the stocks they buy for slightly more than they bought them for.
For those of you thinking, “hey, that sounds like a good business to be in,” you’re right. It is. The bid-ask spread means consistent, reliable profits in bear and bull markets alike. Whether the stock’s price is shooting up or plunging hard, you can keep making money by selling shares for a penny more than you bought them less than a second ago. It’s a way to make money from stock markets without actually assuming any of the risk of owning stocks, which is a pretty sweet gig, all told.
Low Liquidity Trading
For big companies, that bid-ask spread is almost always just $0.01. It might seem like pushing that spread to $0.02 would be an easy way to double your profits, but that’s actually the fastest possible way to get canned, thus eliminating all of your profits.
It’s the exchanges that decide which firms get to act as market makers. The different exchanges, like the Nasdaq and the NYSE, are competing with each other for the chance to list companies, and ensuring that investors won’t get gouged on the bid-ask spread is one way to attract business. Getting a penny on every share traded for a stock that trades millions of shares a day is really easy money, so there’s no real sense in risking your lucrative position as market maker by fiddling with the spreads.
But that basic equation changes if a company’s trading volume is too low. In that case, the company and exchanges need the market maker more than the market maker needs them.
When the demand for a stock is low, market makers can’t be sure every share they buy can be unloaded right away. That means holding the stock for longer periods of time and exposing the market maker to the risks associated with trading stocks. NOT what market makers are in the business for. And the reward for taking on that risk? Low, given that it’s not trading many shares.
The solution is to let the market maker expand the bid-ask spread, allowing them to make more profit per share traded. The potential for additional profit helps balance out the greater risk and lower number of shares traded, giving market makers the incentive they need to jump in.
PURELY HYPOTHETICAL EXAMPLE #2
Let’s return to our previous example of Peter Piper & Co.’s pickled pepper market. Peter Piper & Co. has smoothed out the market for pickled pepper farmers and pickled pepper suppliers looking to buy their crop. However, times are rough. A peck of pickled peppers sells for about $1, so Peter Piper & Co. has a bid price of $1 and then an ask price of $1.01.
Here’s the thing, the price of pickled peppers is volatile. Pickled peppers being an acquired taste, the amount of pickled peppers being bought and sold on any given day can be pretty low. Sometimes, farmers will sell Peter Piper & Co. hundreds of pecks and it will be a day or two before the next big supplier comes through ready to purchase the peppers. During that time, the price of a peck of pickled peppers could fall a nickel or more because of the volatility of the prices. When that happens, Peter Piper & Co. has to sell the peppers they bought at $1 a peck for $0.96 or less, taking a big loss.
Speculators betting on the price of pickled peppers will gladly accept these losses, planning to make it back when things swing their way. A market maker, though, wants no part of it. Why take a chance on pickled peppers, a notoriously volatile market with low liquidity, when you could just as easily be a market maker for carrots. Carrots will only have a $0.01 spread, but they’re bought and sold so fast that you won’t get stuck holding the bag.
That’s why Peter Piper & Co. expands their bid ask spread. Now, when the market price for a peck of pickled peppers is at about $1, their bid price is $0.95 and their ask is $1.05. Now, they’re making $0.10 for each peck sold, making the upside over carrots enough that it’s worth risking the notoriously fickle pickled pepper market.
Neither the farmers nor the suppliers are thrilled about that spread, to be sure. The farmers are making $0.05 a peck less for every peck sold, and the suppliers are paying an extra $0.04 a peck. However, like it or not, they’ll accept it. Again, without the market maker, people spend a lot more time navigating a difficult marketplace. The fee collected by the market maker is more than worth it for the liquidity they provide.
Market Makers – Still Relevant After All These Years
The role of market makers has shifted over time, but their role as facilitators has helped make the stock market into something available and understandable to a wide swath of the population that might otherwise be too overwhelmed by the simple act of buying stock to even get started as investors.
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