What Is a Market Maker? How Market Making Works

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A market maker is a firm or individual that stands ready to buy and sell a security at publicly quoted prices, using its own capital and inventory. It posts a bid (the price at which it will buy) and an ask or offer (the price at which it will sell) at the same time. Other investors can then trade immediately against those quotes instead of waiting for a matching buyer or seller to appear. Market making is the business of doing this continuously, and the market maker’s main source of revenue is the gap between the two prices, known as the bid-ask spread.

How a Market Maker Works

A market maker publishes a quote that has four parts: a bid price, an ask price, and the number of shares it is willing to trade at each. When an investor sends a sell order, the market maker can buy those shares at its bid and add them to inventory. When a buyer arrives, it can sell from that inventory at its ask. The market maker is a principal in these trades. It is not finding a counterparty for you; it is the counterparty.

A registered market maker must quote continuously on both the buy side and the sell side for the securities it covers. It must quote the size it will trade and meet requirements for how much of the time its quotes sit at or near the best bid and best offer. These obligations apply whatever the firm’s own view of the market is. A market maker that expects a stock to fall still has to keep a bid in the market, although it can lower that bid and reduce the size.

Most market makers are large institutions, such as brokerage firms, banks and specialized trading firms, because the role requires enough capital to absorb large order volumes. Individual traders have also made markets. On futures exchanges, for example, an independent trader dealing for their own account is traditionally called a local.

Reading a market maker’s quote

Quotes are usually written as price and then size. A quote of $10.00 to $10.05, 100 x 500 says the market maker will buy 100 shares at $10.00 and sell 500 shares at $10.05. Traders have short names for trading against each side:

• Hitting the bid: selling to the market maker at its bid price ($10.00 here).
• Lifting the offer: buying from the market maker at its ask price ($10.05 here).

The sizes matter as much as the prices. In this example, an order to buy 2,000 shares would fill only 500 shares at $10.05 from this quote. The rest would trade at whatever prices other quotes in the market offer.

Example of a Market Maker

Hypothetical example. A market maker in XYZ stock quotes $10.00 bid and $10.05 ask, 100 x 500.

1. An investor sells 100 shares by hitting the bid. The market maker pays $1,000 and now holds 100 shares.
2. A few minutes later, another investor lifts the offer for 100 shares. The market maker sells them for $1,005.
3. The market maker has earned the $0.05 spread on 100 shares, or $5, before costs such as exchange fees and clearing.

Now change step 2. Before any buyer arrives, negative news pushes XYZ down. The market maker lowers its quote to $9.80 bid and $9.85 ask, and the 100 shares it holds are now worth about $980 at the new bid. If it sells at $9.85, it loses $15 on the round trip instead of earning $5. This is inventory risk, and it explains why the spread exists: the market maker charges a small margin on every trade to cover the trades where the price moves against it.

How Market Makers Make Money

The basic model is to earn a small spread many times a day across many securities. A $0.05 spread sounds trivial, but a firm that turns over large volumes collects it on millions of shares. The profit comes from turnover and short-lived inventory, not from predicting which way prices will go.

Spread income has to cover several costs and risks:

• Inventory risk: shares held overnight or through a news event can lose value.
• Adverse selection: a trader who knows more (for example, someone reacting to news faster) tends to trade with the market maker just before the price moves the market maker’s way, at the market maker’s expense.
• Operating costs: technology, exchange and clearing fees, and the capital required to hold positions.

Firms manage these risks by adjusting quotes as inventory builds up. A market maker holding too many shares can lower both its bid and ask to discourage more selling and attract buyers. Many firms also hedge with futures, options or other correlated securities. The spread is the main control: narrow in heavily traded securities, where inventory keeps moving, and wider in thinly traded or volatile ones, where each position carries more risk. Market makers do lose on individual trades; they are built to profit across the whole flow.

Why Is a Market Maker Important?

Market makers supply liquidity, meaning the ability to buy or sell quickly without moving the price much. Without them, a seller would have to wait for another investor willing to buy the same security at an acceptable price. In a popular large-cap stock that wait may be brief. In a less-traded stock, bond or option series, it could be long, with a large price gap between willing buyers and sellers.

You can trade without dealing with a market maker directly. A limit order on an exchange can be matched with another investor’s order. What the market maker adds is a counterparty that is available continuously. That is particularly valuable during volatile periods, when other participants pull back and continuous quoting helps keep trading orderly.

For an exchange, a market maker program keeps quotes present in every listed security, including ones with little natural trading interest, which makes the venue more attractive to listing companies and investors.

Regulation of Market Makers

Market makers operate under the bylaws and rules of each exchange, and in the US those rules are approved by the Securities and Exchange Commission (SEC). Rights and duties differ by venue and asset class: an options market maker’s quoting obligations are not the same as an equity market maker’s. On Nasdaq, a market maker is a firm that buys and sells securities both for its own account and for customer accounts.

Market makers are subject to the same prohibitions on market manipulation as other participants, such as trading to create a false impression of supply or demand. Moving quotes quickly in response to orders and news is legitimate quoting, not manipulation. In a security with several competing market makers, a quote that strays far from the market tends to be undercut by rivals or traded against.

Market Makers vs. Designated Market Makers

Many exchanges, including Nasdaq, have several market makers competing in the same security. Each one tries to win orders by posting a better bid, a better ask or larger size.

The NYSE uses a different structure. Each listed security is assigned to a single designated market maker, formerly called a specialist. The NYSE is an auction market, where investors’ bids and asks compete with one another, and the DMM has specific responsibilities within that auction:

• displaying bids and asks to the whole market and making sure they are reported accurately and promptly;
• maintaining a fair and orderly market, including making sure marketable trades are executed at the best available price;
• setting the opening price each trading day based on supply and demand. That price can differ from the prior close when news has arrived outside trading hours.

NYSE DMM firms have included Citadel Securities, GTS Securities and Virtu Americas.

Market Making on Other Major Exchanges

Market making exists on exchanges worldwide, though the terminology varies. On Xetra, Deutsche Börse’s electronic trading platform in Frankfurt, market makers are called designated sponsors, and firms on its list have included Berenberg, JPMorgan and Optiver. The London Stock Exchange Group, Japan Exchange Group and Toronto Stock Exchange also maintain market maker lists, which change over time.

Limitations of a Market Maker

Market makers make trading easier, but their role has clear limits:

• They do not set fundamental value. A market maker reacts to order flow and news. If sellers overwhelm buyers, quotes fall, and the market maker’s job is to keep trading orderly, not to stop the decline.
• Spreads widen under stress. Quoting obligations require a two-sided market, not a tight one. In fast markets, the bid and ask can move far apart and quoted sizes can shrink, which makes trading more expensive at the moment many investors want to act.
• The spread is a cost to investors. Every round trip at the bid and ask gives up the spread. Using limit orders can reduce that cost, but a limit order may not fill.

Market Maker vs. Broker, Dealer and Underwriter

These roles are often confused:

• Broker: acts as an agent, routing your order to a venue and charging a commission or fee. A broker does not have to take the other side of your trade.
• Dealer: trades as a principal from its own inventory. A market maker is a dealer that has taken on continuous two-sided quoting. All market makers are dealers, but not every dealer has market-making obligations. Many firms are registered as broker-dealers and act in both capacities.
• Underwriter: helps an issuer sell new securities in an offering. Market makers trade shares that are already outstanding in the secondary market, so they generally obtain inventory from other investors, not from the issuing company.

In investment banking, “market making” usually means a trading desk quoting prices to clients in stocks, bonds, currencies or derivatives: the same principal activity, often carried out away from an exchange.

FAQs

The Bottom Line

Anyone who buys or sells securities pays the bid-ask spread that market makers earn, so the spread is a real trading cost. Market makers keep trading available continuously, but they do not set fundamental value, and their spreads can widen sharply in fast markets. Using limit orders can reduce the spread cost, with the tradeoff that a limit order may not fill.