Throughout the day, hundreds to thousands of traders buy and sell securities in the public exchange. These transactions are usually executed within a few seconds. Have you ever wondered how these transactions are done in such a short time?
Whenever a transaction is executed, there must be someone on the other end that is willing to make the trade. It seems to be an unlikely coincidence to find someone interested to do exactly the opposite of the transaction with the same number of shares at the same time. This is where the role of market makers comes into place.
What is a market maker?
A market maker is a broker-dealer firm that acts as a liquidity provider. Market makers are always available throughout the whole trading day with a bid and ask price for a security. Whenever an investor places a market order to sell a hundred shares of a certain company, the market maker is actually the one who purchases the stocks instantly from the investor, even if there are no other investors interested in that security. Thus, the firm does its role in creating a “market” for that certain stock.
Without these market makers, the queue to process a transaction will surely be long as buyers and sellers would need to be matched up with exactly the same terms in order for the trade to become successful. This would result to a reduced liquidity and larger trading costs and fees.
How do they make money?
Market makers have a very big role in trading, not only in helping hasten the process of trading itself, but also the risk that comes with it is great as well. Because of this, market makers should be well compensated. But how are they actually paid back? Let us consider the following scenario:
An investor sells a hundred shares of company ABC. In an instant, the market maker purchases the shares for $50 each (the ask price), and then offer to sell them to potential buyers at $50.08 (the bid price).
In the said example, the market maker added a little amount to the price of the stocks, which in this case is $0.08. The difference between the bid and ask price is the spread that is given as a payment to the market maker. It may seem like a very small amount, but the huge volume of trades done each day could result to a significant amount at the benefit of the market maker. This spread is the offset of the risk that the market maker is willing to take, since there is really no assurance that a stock price would not fall before a willing buyer is matched to purchase the shares held by the market maker.
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