If you've ever idly wondered who was on the other side of your most recent stock or options transaction, the answer is reassuringly dull: It was most likely a professional market maker whose full-time job is to be the anonymous investor on the other end of your every trade. But what is a market maker?
"Market maker" is the broad term used to describe the parties, whether firms or individuals, whose primary function is to keep markets running in a smooth and orderly manner. Their role is to be the buyer to your seller, or the seller to your buyer.
Even for relatively unpopular or lightly traded assets, market makers are in place to provide liquidity and, in a very literal sense, "make the market" by buying and selling inventory to meet whatever demand may exist.
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What does a market maker do?
On a practical level, market makers achieve this by continuously quoting buy and sell prices on the assets they hold in their inventory. Registered market makers are obligated to fill orders from their own inventory within range of these quoted prices, providing a certain level of both immediacy and transparency to these transactions.
The highest price a buyer is willing to pay for a security is known as the "bid," while the lowest price a seller is willing to accept is the "ask." Typically, the bid price will be lower than the ask price, and the difference between the two is known as the "bid/ask spread."
Prices are set by market makers based on supply and demand. Stocks like Apple (AAPL) that are in greater demand among traders and investors tend to have higher daily volume, which generally translates into narrower bid/ask spreads. On the other hand, an asset that's lightly traded with thinner daily volume levels is likely to have wider bid/ask spreads.
How do market makers make money?
Regardless of an individual asset's popularity, market makers provide liquidity to meet whatever level of investor demand might exist. In return for providing this essential function, market makers are able to profit by capturing the spreads between bid and ask prices.
While the bid/ask spread may be relatively small on highly liquid securities – sometimes as tight as one penny – bear in mind that market makers will pass a far greater volume through their books than the average investor. Meanwhile, less active and relatively illiquid assets will yield wider spreads and comparatively greater "passive profits" for the market maker.
Additionally, market makers can profit from their role as liquidity providers during periods of increased volatility for stocks. When there's a large buy or sell imbalance, market makers can pick up greater amounts of inventory to help absorb the increased volatility, then gradually unload that inventory at more favorable prices as market conditions permit.
Notably, the New York Stock Exchange (NYSE) uses "designated market makers" (DMMs) to help facilitate orderly opening and closing auctions. DMMs have higher capitalization requirements than traditional market makers, and are unique in that they typically specialize in specific stocks, rather than making markets for a wide variety of names. In fact, this role was previously known as a "specialist."
Some of the well-known firms that act as market makers include Goldman Sachs (GS), Credit Suisse, Citadel Securities, and TD Securities – though not all brokerage firms or investment banks act as market makers.
Finally, while quite a few urban legends and cautionary trading tales would suggest that market makers are actively manipulating stock and options prices in a specific effort to foil retail traders, that's certainly not the assignment. For what it's worth, the activities of registered market makers are regulated by both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
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