A market maker is typically a large bank or institution. They help ensure the liquidity of a market by offering to both buy and sell securities. As an investor, there are some things you need to know about market makers. Here’s how they work, why they’re important to the market, and how they use supply and demand.
A market maker is a trader whose primary job is to create liquidity in the market by buying and selling securities. Market makers are always ready to buy and sell within the market at a publicly-quoted price. Usually, a market maker is a brokerage house, large bank, or other institution. However, it is possible for individuals to be market makers, as well.
As the name suggests, market makers “create the market.” In other words, they create liquidity in the market by being readily available to buy and sell securities. This creates liquidity within the market. Most importantly, it helps other trades occur smoothly. Without market makers, the market would be relatively illiquid, which would prohibit the ease of trades.
Here’s how it works: When you sell 5,000 shares of a particular stock, a market maker will purchase it from you at what’s called the bid price. Then, they’ll turn around and sell it to a buyer at the ask price. Market makers can then sell these purchased securities to broker-dealer firms within their exchange. Keep in mind that when market makers purchase securities, they don’t always have a buyer lined up right away.
Why It Matters
Market makers assure that the market stays liquid, which is important so that other trades can occur. They also are readily available to “make the market,” i.e. buy or sell according to a publicly-quoted price and create a more liquid market.
Supply and demand is also important to market makers. That’s because market makers update prices to reflect current supply and demand which, as you know, is always changing. Important to note: Market makers have to constantly update their buying and selling prices to reflect the market conditions, i.e. supply and demand.
Remember, supply is the amount of something for sale (think a commodity, item, even a service), while demand indicates whether a buyer wants to purchase it or not. It’s an important concept not just in economics, but in the financial world, as well.
Market makers also help regulate the prices of under or overvalued securities. Since market makers can control the amount of a security within the market, and therefore set the prices for these securities based on supply and demand, they can help increase the price of an undervalued stock by raising its price, or decrease the price of one that’s overvalued by lowering its price.
Basically, since they control the amount of stocks within the market, they can adjust the prices based on inventory. (Remember, supply and demand.) This helps regulate the market.
How a Market Maker Profits
We already know that market makers keep the market liquid by buying and selling securities according to publicly-quoted prices. This keeps the market running smoothly. But they also stand to make money from these transactions.
When a market maker purchases a stock, they do so at the bid price. Then when they sell these securities, they do so at the ask price. This is the price at which their firm is willing to sell these particular securities. (Remember, most market makers work for larger brokerage firms.) The spread, or difference, between these two numbers is called the bid-ask spread. The bid-ask spread represents the market maker’s profits. Additionally, market makers earn a commission for creating liquidity for their clients.
The Bottom Line
A market maker plays an important role in the financial markets. They are readily available to buy and sell securities, thus creating liquidity in the market. Without market makers, the market would be relatively illiquid and other trades would be impacted.
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