Market Makers Definition Method Strategy Who Are They

Market Makers Definition

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They are different from brokers who charge a commission to find the right match for the deals. Instead, market players purchase shares at a bid priceBid PriceBid Price is the highest amount that a buyer quotes against the “ask price” (quoted by a seller) to buy particular security, stock, or any financial instrument. read more and sell at an ask priceAsk PriceThe ask price is the lowest price of the stock at which the prospective seller of the stock is willing to sell the security he holds. In most of the exchanges, the lowest selling prices are quoted for the purpose of the trading. Along with the price, ask quote might stipulate the amount of security which is available for selling at the given stated price.read more. The difference between the two prices, also termed bid-ask spread, is their profit.

Key Takeaways

Market Makers Explained

Market makers can be investment banks, financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more, or brokerage houses. These entities take the responsibility to keep the market active and balanced. The market-making individuals make the market, and their absence might break or lead to the market’s collapse. Thus, they play a significant role in increasing the efficiency of the financial marketplace.

A market maker can either be an individual or a member firm of a securities exchange. Through regular purchase and sale of stocks, they ensure the market remains active and liquid. Even when markets are volatile, these market participants ensure being calm and patient to take control over them. This quality enables them to maintain significant trade volumeTrade VolumeThe volume of trade is the overall measure of the number of securities, shares or contracts traded during a particular trading day. read more even in the worst scenarios, facilitating smooth trading activities.

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. Instead, they sell their inventory to complete multiple orders simultaneously. They keep finding buyers for the available securities and continue trading activities without any pause. This is why they are identified as market makers who build the market by keeping it efficient all the time.

These market participants look for the best bid price and provide the most reasonable offer price for the shares, keeping in mind the variations hitting the market from time to time. This way, they ensure traders willingly connect with them to grab the most profitable deals. The rights and responsibilities of these individuals depend on the exchange they are associated with and the financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more they deal with.

The Market Making Process

The market makers strategy lies in the process they adopt and proceed with towards converting an illiquid market into a liquid one.

With the market-making individuals and entities functioning in the market, the sellers and buyers do not have to struggle in finding a buyer or seller for their securities. Instead, they represent both sides of the financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more. Whether traders show their interest in buying shares or selling them, they tend to support both.

When they meet the sellers of shares with a fixed bid price, they enter as a buyer and purchase the securities. As soon as they own those shares, the ask price is determined, taking into account the market fluctuations. The difference between the cost price of the shares and the selling price is the profit they make. Though the difference between the ask price and bid price for each share is low, the stocks altogether offer huge profits to these market players daily.

The market-making individuals or firms need to comply with the law of the nation they operate in. The stock exchangesStock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more work on certain guidelines approved by the regulators of a nation’s financial market. The market makers must follow the same to operate as an authorized trading body. In the United States, the Securities and Exchange Commission (SEC) approves and takes care of the legal perspectives of the financial markets.

Market Maker Examples

Let us consider the following examples to understand how the concept works in the financial market:

Example #1 – (Conceptual)

Company X is eager to sell its shares at $90 per unit. Sarah, a market maker, buys a set of shares from the company and fixes the ask price of $90.5 for the same. Ralph comes across the offer and finds it quite reasonable, expecting the market pricesMarket PricesMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more to go up significantly in the next few days. Thus, he purchases 100 shares from Sarah. Though the bid-ask spread that becomes her profit is low, i.e., $0.5, she closes and manages a significant earning against a single deal with $50 for selling those 100 shares.

Example #2 – (Market Makers FOREX)

Market Makers vs ECN

Investors often use market makers and Electronic Communications Networks (ECNs) synonymously. This is mainly because of the similarities that both these entities appear to share. However, they both are completely different in terms of who they are and how they function.

Market makers are individuals or firms representing buyers and sellers in a financial market. They buy sharesBuy SharesKnowing how to buy shares is crucial for a person who wants exposure to the equity market. Equity markets are volatile, and timing is very important. Shares trade in exchanges, but you just can’t go and buy a share from the exchange. There are several steps involved in purchasing a share.read more at one price (bid price) and sell them for another price (ask price), slightly higher than what they paid. Both the prices are put on their screens. The bid-ask spread is their profit.

These market participants become sellers to interested buyers and buyers to interested sellers. They price the shares as per their best interests.

ECNs, on the other hand, work with respect to market fluctuations. They study the shares and the prices at which they are being traded in the market. The network sets the best bid/ask price for the stocks depending on their study. The brokers match buyers’ and sellers’ shares and price requirements and become a middleman for further settlement. These networks earn through commissions they receive for each transaction that occurs.

Market Makers Definition Method Strategy Who Are They