The market-maker spread is the difference between the price at which a market-maker (MM) is willing to buy a security and the price at which it is willing to sell the security. The market-maker spread is effectively the bid-ask spread that market makers are willing to commit to. It is the difference between the bid and the ask price posted by the market maker for security.
This spread represents the potential profit that the market maker can make from this activity, and it's meant to compensate it for the risk of market-making. The risk inherent in a given market can affect the width of the market-maker spread: High volatility or a lack of liquidity in a security will tend to increase the size of the market-maker spread.
Key Takeaways
The market-maker spread is the difference in bid and ask price set by the market makers in a particular security.
Market makers earn a living by having investors or traders buy securities where MMs offer them for sale and having them sell securities where MMs are willing to buy.
The wider the spread, the more potential earnings an MM can make, but competition among MMs and other market actors can keep spreads tight.
High volatility or increased risk can lead to MMs widening their spreads to compensate.
Market makers' job is to add liquidity to markets by being ready to buy and sell designated securities at any time during the trading day. While the spread between the bid and ask is only a few cents, market makers can profitby executing thousands of trades in a day and expertly trading their “book.” However, these profits can be wiped out by volatile markets if the market maker is caught on the wrong side of the trade.
Market makers, who may be either independent or an employee of financial firms, offer to sell securities at a given price (the ask price) and will also bid to purchase securities at a given price (the bid price). MMs earn a living by having market participants buy at their offer and sell to their bid over and over again, day in and day out.
The market-maker spread can be considered a measure of the liquidity (i.e. the supply and demand) of a particular asset. As market makers are more willing to bid or offer, there are larger sizes on the spread, and larger volumes can transact without moving the market too much. Market-maker spreads tend to be tighter in more actively traded names, and in those that have more market makers available to make markets.
Special Considerations
Rather than tracking the price of every single trade in Alpha, MM’s traders will look at the average price of the stock over thousands of trades. If MM is long Alpha shares in its inventory, its traders will strive to ensure that Alpha's average price in its inventory is below the current market priceso that its market-making in Alpha is profitable. If MM is short Alpha, the average price should be above the current market price, so that the net short position can be closed out at a profit by buying back Alpha shares at a cheaper price.
Market-maker spreads widen during volatile market periods because of the increased risk of loss. They also widen for stocks that have a low trading volume, poor price visibility, or low liquidity.
Example of Market-Maker Spread
For example, imagine that a market maker MM in a stock – let’s call it Alpha – shows a bid and ask price with a quote of $10.00 - 10.05. This means that this MM is willing to both buy Alpha shares for $10 and sell it at $10.05. The spread of 5 cents is the potential profit per share traded to the market maker. If MM can trade 10,000 shares at the posted bid and ask, its profit from the spread would thus be $500.
The bid price is the amount of money a buyer is willing to pay for a security. It is contrasted with the sell (ask or offer) price, which is the amount a seller is willing to sell a security for. The difference between these two prices is referred to as the spread. The spread is how market makers (MMs) derive profits.
and ask price set by the market makers in a particular security. Market makers earn a living by having investors or traders buy securities where MMs offer them for sale and having them sell securities where MMs are willing to buy.
For example, consider an investor who sees that Apple stock has a bid price of $50 and an ask price of $50.10. What this means is that the market maker bought the Apple shares for $50 and is selling them for $50.10, earning a profit of $0.10.
An illustrative example of a spread used in trading is a bull call spread. This is a bullish options trading strategy that involves the purchase of a call option with a strike price that is below the current market price, and the simultaneous sale of another call option with a higher strike price.
The most common example of a market maker is a brokerage firm that provides purchase and sale-related solutions for real estate investors. It plays a huge part in maintaining liquidity in the real estate market.
There are also more active market making strategies that involve taking positions in the market to influence the bid and ask price. For example, a market maker may buy a large amount of a particular cryptocurrency to push up its price and then sell it at a higher price to make a profit.
The market-maker spread is the difference between the price at which a market-maker (MM) is willing to buy a security and the price at which it is willing to sell the security. The market-maker spread is effectively the bid-ask spread that market makers are willing to commit to.
In October 2020, Citadel Securities announced it would acquire the NYSE market making unit of rival IMC. The purchase made it the largest designated market maker (DMM) on the NYSE — overseeing over 1,500 NYSE-listed securities.
To make a market means to be willing to trade a security against a counterparty by producing a firm bid to buy and offer to sell. Market makers display buy and sell quotes for a guaranteed number of shares, take orders from buyers, and then sell shares from their inventory to complete the order.
They are obligated to post and honor their bid and ask (two-sided) quotes in their registered stocks. There are three primary types of market making firms based on their specialization: retail, institutional and wholesale.
Brokers are typically firms that facilitate the sale of an asset to a buyer or seller. Market makers are typically large investment firms or financial institutions that create liquidity in the market.
How do market makers make money? Market makers profit by buying on the bid and selling on the ask. So if a market maker buys at a bid of, say, $10 and sells at the asking price of $10.01, the market maker pockets a one-cent profit. Market makers don't make money on every trade.
A market makers method is concerned with matchmaking, whereby they find buyers interested in purchasing shares at the ask price at which they are available. Once they find the matches for the volume of shares they bought from sellers, they sell them. These market entities do not purchase one share at a time.
Market makers set prices based on supply and demand. If there is more demand for a stock than there is supply, the market maker will increase the price. If there is more supply than there is demand, the market maker will decrease the price.
Examples of New York market makers are Optiver, Jane Street Capital, Flow Traders, IMC, and Virtu Financial, according to Article 17(13) of Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012.
There are three primary types of market making firms based on their specialization: retail, institutional and wholesale. Retail market makers service retail brokerage customer orders.
Robinhood makes money in many ways, notably through a system known as payment for order flow. That is, Robinhood routes its users' orders through a market maker who actually makes the trades and compensates Robinhood for the business at a rate of a fraction of a cent per share.
To make a market is to display a bid (where you are willing to buy) and an ask or offer (where you are willing to sell). If you were a grocer, for instance, and were asked to make a market on the price of an apple, you might indicate $0.10 - $0.50 ("ten cents bid at fifty cents").
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