Warrior Trading Blog

Market Maker Explained For Beginners

Market maker

 

A market maker is a broker-dealer who has been certified, and/or has met capital requirements, to facilitate transactions in a particular security between the buyer and sellers.

They typically hold a lot of inventory of shares in that security so they can fulfill large amounts of orders in a moments notice.

market maker

 

How Market Makers Work

Market makers are highly capitalized traders who profit by providing liquidity to the rest of the market.

They’re ‘making the market’ by ensuring traders can always buy or sell, hence the name ‘market maker.’ Market makers come in many forms.

Some trade their own account for profit, while exchanges or issuers hire others to maintain orderly trading and ensure traders can buy or sell easily. 

By placing orders on both sides of the market, market makers remove most directional risk from their trading.

Every day traders like you and I aim to buy a stock and wait for it to go up. Market makers are more like a grocery store, buying at “wholesale” prices and passing them onto their customers for a slight premium.

They aim to capture a piece of the “spread,” which is the difference between the best bid price and the best offered price. 

Market making used to take place in the trading pit by floor traders.

You’d call your broker to place an order, and your broker would send one of their staffers down to the trading pit to hand the ticket to a trader. The process definitely wasn’t instant.

Even everyday traders can now send a digital order ticket to exchanges or electronic market makers with a button click. 

Conceptually, the process of market making is the same today, but the venue is very different.

Nowadays, most market making is done by computers, with little human interaction in actual trading. Humans instead develop highly sophisticated algorithms and allow them to trade unfettered.

The contrast between the market maker of today and yesterday is staggering.

The floor traders were tall and broad-shouldered men, often from a competitive sports background because of pit trading’s physical aspect.

Alan Knuckman, a former floor trader, writing for St. Paul Research, said he was “disparagingly told I was hired because of my 6 foot 3 height to be seen on the floor, not my intelligence – but I beg to differ.”

Floor traders were rarely mathematical geniuses and instead honed market intuition through social cues from other traders in the pit and back-of-the-napkin calculations.

Today’s electronic market making has no physical requirements and instead is made up of the brightest minds in computer science, mathematics, and quantitative finance.

Modern-day market making is intensely competitive, requiring near-perfect execution of their algorithms. Floor traders used to fight over 12 cents, which was the tick-size, or the smallest price change in a stock.

Electronic market makers now fight over less than a penny. 

To summarize: market makers profit by always making a market.

They offer bids and asks to both sides of the market to earn the bid/ask spread. Should they wind up with too much exposure on one side of the trade, many will use other instruments like options, futures, and swaps, to hedge their exposure. 

Luke Posey on Towards Data Science drew a great visual representation of market making activities:

 

How Market Making Became Electronic

Before the advent of sophisticated electronic trading technology, floor traders were the primary market makers on major exchanges.

Floor traders stood in large trading ‘pits,’ where they used their own hand signals and jargon to communicate with each other.

One of the first significant blows to the physical trading pits was the Nasdaq SOES electronic trading system.

It was essentially a direct route to trade with the floor traders but was only accessible if your trade was less than 1,000 shares.

These small SOES traders had a huge advantage: the SOES system executed orders immediately, while floor traders had to manage their quotes manually. 

For example, let’s say some great, unexpected news comes out for a stock.

The SOES traders, sitting at their computers, would be able to instantly buy the stock using the “stale” quotes posted by floor traders.

Because they had to do things by hand, it might take them a minute to adjust things, but they had to honor quotes executed through the SOES system, so they were consistently getting burned. 

See our article on these “SOES Bandits” here. 

The SOES system was just one of several technological innovations that were slowly eliminating floor traders, but its story is most emblematic of their downfall.

The Different Roles of Market Makers

Market makers can trade their own accounts for profits or perform market making duties on behalf of an exchange or security issuer.

Large exchanges desire orderly markets and hence have “designated market makers” to help facilitate trade. However, some exchanges expect issuers to hire their own market makers to manage trading activity in their stock. 

The New York Stock Exchange has designated market makers that they deem primary market makers for several stocks.

While still trading their own accounts, these market makers must carry out specific functions like reducing market volatility, increasing liquidity, and balancing their inventory. 

Then you have individual market makers.

These are firms that simply deploy market making strategies in certain markets without any designations. Outside of following relevant legal and exchange regulations, they don’t have the obligations that DMMs have. 

Security issuers hire the third type of market makers. This is typically the case on smaller exchanges that don’t already assign DMMs to their listed issues.

One example of such an exchange is Canada’s TSX Venture (TSXV) exchange, which lists smaller, emerging issues primarily in the mining industry. 

How Do Market Makers Profit?

Capturing The Bid/Ask Spread

Market makers aim to capture the bid/ask spread. There’s a bid price in any exchange-traded market, which is the highest price a buyer is currently willing to pay, and an ask or offer price: the lowest price a seller is willing to sell for.

The market makers’ main goal is to buy at the bid and immediately sell at the offer (or sell at the ask and instantly buy at the bid).

They do this by being “first in line” to buy on the bid when a seller “crosses the spread” with a market order.

It’s easier said than done, though, especially in today’s highly competitive electronic market. Most market makers are pleased collecting just a fraction of a penny by transacting at prices between the spread. 

Have you ever purchased a stock and received an oddly priced fill? You may have placed an order to buy at $10.00 but were filled at $9.996?

That’s because your broker sent your order to a  market maker, and they sold it to you at that price, probably because they bought it for something like $9.994. These sub-penny profits are the norm in modern market making.

But because they make so many trades so quickly, the profits add up very quickly. 

Market making is a game of very small edges.

What was once $0.125 (an eighth of a dollar, the smallest tick size before decimalization), is now less than a penny. In any game with tiny edges, the real money is made in repetition.

Imagine you have a weighted coin. Tails have a 51-49 advantage.

Over 100 flips, you only stand to make, on average, one cent.

However, if you could flip the coin millions of times, you can stack up a nice profit. While market makers don’t have the certainty of a weighted coin, this is how they think about their trading.

They don’t care about the results of any individual trade, and instead focus on the profitability over thousands or even millions of trades.  

Exchange Rebates

Another way market makers profit is by taking advantage of the rebate systems of stock exchanges.

If you’ve ever traded with a direct market access broker, you probably know that there are dozens of stock exchanges out there.

They’re not exchanges in the traditional sense of listing companies, but they’re trading venues where you can send orders to transact with other traders. 

Exchanges make money when people trade on their system.

To incentivize traders to use them, they all offer slightly different rebates for routing your quotes.

The most famous exchange pricing model is known as “maker-taker.” The maker-taker model gives those providing liquidity a small ‘maker’ rebate (usually something like $0.004/share), and charges those taking liquidity a small ‘taker’ fee, also typically around $0.004/share. 

This model incentivizes traders to provide liquidity (providing liquidity refers to routing a non-marketable order which doesn’t immediately interact with the current bid or ask).

Because market makers are primarily liquidity providers, these fees are another profit source for them. It’s a win-win for the exchanges and market makers.

Exchanges can attract more business because they have the liquidity, and market makers

How Has Electronic Trading Changed the Markets?

The last three decades of radical technological change and computing power growth have forced traders to adapt or die.

Many floor trading millionaires couldn’t adapt to sitting in a chair staring at screens and have since changed career paths.

Some prop traders who relied upon their speed edge to snipe quotes have seen high-frequency traders uproot them. Some trading patterns simply don’t work anymore because of the increased noise created by high-frequency traders. 

Most traders dealing in the short-term (less than an hour) have been forced to make significant adjustments.

These changes really compounded with the Great Financial Crisis, which killed off countless DIY quantitative traders and scalpers.

Bottom Line

Traders complain about market makers on trading message boards and social media regularly.

Their complaints reached a fever pitch around the release of a string of books in the early 2010s, most notably Michael Lewis’ Flash Boys. 

While there are certainly legitimate concerns about how markets have changed due to high-frequency trading, the only thing we can do is adapt.

Holding trades for a few seconds is mostly dead, save for the most expert scalpers.