Market Making is simpler than you think!

8 min read

By Chainika Thakar, Nitin Thapar & Milind Paradkar

Over the past few years, you must have witnessed a sharp positive shift in the financial markets, mainly because of rapid advancement in technology recently. Ever since the advent of technology, trades take place at an extremely high pace. Speaking about technology, mentioning Algorithmic Trading is a must. With Algorithmic Trading, the buying and selling (of stocks) occur rapidly every second.

Edward Leshik and Jane Cralle, the authors of the book, “An Introduction to Algorithmic Trading”, have put down the explanation of Algorithmic Trading in the following words, “In order of complexity, the Markets rank a good 4th after the Cosmos, Human Brain, and Human Immune System.”

In today’s ever-changing markets, market participants play an extremely imperative role. Coming to the core of this article, a key market participant in an exchange’s trading structure is the Market Maker. To understand in detail about Market Making, let us see what all this article covers:

Who are Market Makers and what is Market Making?

Market Makers are those who buy at the best bid in the current market scenario and also, sell at the best offer. This way, they indulge in both sides of financial markets. Hence, by doing so, they make a market, which shows in the last stock price in the market. Although the Market Makers buy and sell in accordance with the current market situation, they refrain from making the transactions in case of extreme volatility.

So every market-maker functions by displaying buy and sell quotations for a specific number of securities. As soon as an order is received from a buyer, the Market Maker sells the shares from its own inventory and completes the order. And, this process increases the liquidity in the market. Hence, it is known as Market Making Strategy.

Key takeaways from Economic Times:

  • Market Makers are member firms appointed by the stock exchange to inject liquidity and trade volume into stocks.
  • Each Market Maker displays buy and sell quotations for a guaranteed number of shares.
  • Once an order is received from a buyer, the Market Maker immediately sells from its own holdings or inventory of those shares to complete the order.
  • The Market Maker is compensated for the risk by being allowed to offer two-way quotes in the market, consisting of the buy and sell prices quoted together, the difference being the profit.
  • The framework of Market Makers reduces the time required to execute a trade and the cost of transacting in that stock, allowing a large number of shares to be traded.

Alright now! Let us go ahead and see how the Market Makers earn and how much they make out of the earnings.

How do the Market Makers Earn and how Much do they Make?

Generally, Market Makers profit by charging higher ask prices (selling) than bid prices (buying). The difference is called the ‘spread’. The spread compensates the market makers for the risk inherited in such trades which can be the price movement against the market makers’ trading position.

For example, the market maker may purchase 1000 shares of IBM for $100 each (the ask price) and then offer to sell them to a buyer at $100.05 (the bid price). The difference between the ask and bid price is only $.05, but by trading millions of shares a day, he manages to pocket a significant chunk of change and offsets his risk of the price moving against him.

Now, coming to how much the Market Makers make, according to Glassdoor it is roughly anything between $66,658 to $95,648 per year.

Let us find out ahead in the article if Market Makers end up losing any money or not.

Can Market Makers Lose Money?

As mentioned above, the primary risk a Market Maker can face is a decline in the value of a security after it has been purchased from a seller and before it's sold to a buyer.

Market Makers are always counterparties to trades done by informed traders and in case of any volatility in the market; the Market Makers are often stuck with wrong positions.

market makers manages to pocket a significant chunk of change to offset their risk

Another fatal risk for a Market Maker is not to have the latest information. In simple words, Market Makers can manage risks and survive only if it is possible for them to receive & respond to information quickly. Or else, the market position can go against them even in a few seconds, and that can lead to losses.

fatal risk for market maker

Hence, it is really imperative for strong markets to have strong Market Makers that survive without incurring huge losses.

Okay, let us now see why market-making is considered so important for the markets and investors alike.

Why is Market-Making Important?

Generally speaking, market makers help financial markets by maintaining the efficiency of their operations. This makes market-making really important for financial markets. If we take out market-makers, there would not be many transactions taking place in the market. This is the reason that market makers have been an integral part of market infrastructure. Moreover, it is expected that their influence will continue as long as we trade financial assets.

Let us now see ahead how market-makers help with Price Volatility and Impact Cost:

Price Volatility

Coming back to the topic of discussion, Market makers also help reduce price volatility which leads to fair pricing of the assets.

For instance, any given asset has the difference between the best bid and best ask, which is known as the bid-ask spread. Here it is important to note that low liquidity in the markets leads to the wide bid-ask spread. Now, in order to get rid of the wideness in the bid-ask spread, market makers jump in and provide liquidity to the markets.

See the example below to understand that the difference between prices of consecutive trades done against a human market maker will be much higher than those done against an automated market maker. And hence, asset price volatility reduces. Also, ahead we will understand how an automated market maker is more efficient than a human counterpart.

Price Volatility

Impact Cost

Since the market makers function with programmatic execution and algorithms which integrate with exchange APIs, it increases their efficiency. And, with that, it leads to better profits since a robust API helps the market makers with reliable up-times and consistent liquidity.

With automation rendering Market Making easy, order books have become thick. Execution price for even big orders are close to a fair price, Impact cost & volatility is thus lower.

Impact Cost

The overall positive impact of algorithmic Market Making can be summed up as mentioned below:

impact of algorithmic Market Making

Let us now move ahead and learn about the role of automated trading in Market Making.

How automated trading Enables Market-Making?

Since automated systems are more efficient than human beings in detecting & responding to risk-oriented events, it is observed that automated systems help market makers considerably. Factually, to be efficient, market makers should be able to adjust their quotes immediately in response to market events. But a human being can work only at a particular pace which is comparatively much lesser than the pace of an automated system.

There could be several such events in which the market makers would be needed to react promptly so as to be able to gain out of them. For instance, these are the two of those events:

  • Changes in the prices of financial instruments, and
  • Trading positions accumulated by the market maker

Since automated systems can handle their risks much more accurately than humans, they offer better quotes for the Market Makers. While using automated systems for Market Making, you get:

  • Faster response time
  • Scalability and
  • 24x7 Availability

Faster response time

Pricing of derivatives that enable investors to hedge often involves time-consuming mathematical calculations. While humans can take minutes, automated systems are so fast that they can do these calculations in microseconds. Hence, they operate with much more faster response time.

Faster response time

Scalability

Speaking of scalability, while human traders can only track activities in a few instruments, automated systems can do the work in thousands of them simultaneously. Also, an automated trading system provides liquidity in significantly more financial instruments.

Scalability

24x7 Availability

We are mentioning 24x7 availability in a literal sense here since machines do not take or need any breaks. As machines can go on working all the time and that too without any errors, they are much faster along with being accurate.

Availability

Moving ahead, let us see how Brokers and Market Makers are different from each other.

Difference between a Broker and a Market Maker

It is a well-known fact that there are many market participants who play important roles in their own ways in financial markets. However, market makers and brokers are two such participants who differ by various points, although both help the financial markets. Since they are often confused with Market Makers, we will see the points where they differ.

Since you already know who Market Makers are, let us read briefly about Brokers.

Who are Brokers?

Brokers are the individuals who sell and buy stocks on behalf of the investors (clients). They are regulated and need registration with the Financial Industry Regulatory Authority (FINRA).

To help your understanding of the difference between Brokers and Market Makers easier, we have put below the main points of differentiation:

Awesome! With a thorough read of this article you must have got a fair understanding of Market Making. Moving on to the conclusion, let us briefly see what all we have covered so far.

Conclusion

In this article, first, we learnt all about Market Making Strategy, Market Makers, as well as how and how much they earn. With Market Making Strategy, the market makers perform from both the sides i.e., by buying and selling in the markets. This way they not only create the market, but also earn profit by selling at a slightly higher price than the market price. After that we found out the role of automation in making Market Makers stronger, the relevance of Market Making, and the difference between a Broker and a Market Maker.

Great! We will call it a perfect start to your endeavour in Market Making.

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