What are Market Makers?
Many of us think that when we buy or sell a stock, there is another investor just like us who is willing to be on the other side of the trade. What if there isn’t? A market maker is the one who facilitates the transaction and generates maximum transaction flow.
A market dealer is a company that keeps the markets running efficiently by offering both the bid and offer prices for any stock (this means that they are obliged to honor the trade at the size that they indicate) to allow buyers to enter the market and sellers to exit in a timely and orderly manner. Market makers will also buy or sell from their own inventory and the difference between the bid and ask price, or the spread, is their profit.
As an example, you may see a bid and offer from one market maker like this (in all stock quotes, each lot equals 100 shares):
$41.72-41.82 (2X20) they are willing to buy two lots at $41.72 and willing to sell twenty lots at $41.82
A market maker has to buy 200 shares from you at $41.72 if that is what your order is. He can either add the 200 shares to his own supply of stock or immediately find someone to sell it to at $41.82. Your total order may be 500 shares to sell and the remaining 300 may be sold to a competing market maker but you will not be able to see the depth of the market or who is bidding and asking at what volumes until you subscribe to Level 2 quotes. (for more information see the discussion on market maker strategies)
Market makers also set opening prices. During earnings season, it can be common after the release of favorable results for the opening price of a stock to be sharply higher compared to its previous closing price. For example, after its blowout quarterly results after hours on April 20th 2011, Apple’s stock opened significantly higher at US$355.00 after closing at US$342.41 the day before. The market maker has to set the price and if the spread is wider than normal at the start or end of the day ahead of any corporate event, it is to protect themselves from any sudden moves.
Market makers try to set prices that equalize supply and demand, but that doesn’t mean they establish equal buy and sell prices. That is determined by supply and demand. If a market maker has too low a bid, he or she will not be able to find enough shares to buy, and therefore not enough shares to sell to a potential buyer during the course of the day. If their bid is too high, there will be a deluge of shares which the market maker is obligated to buy. If the offer price is too high, the market maker won’t be able to sell enough shares, resulting in an oversupply on their own books.
If there is an imbalance between demand and supply, the market maker has to buy or sell from his own inventory. If buyers are bullish and are snapping up every size of trade, the market maker must sell from his own books, albeit at increasingly higher prices until a balance is reached. If you think that a market maker is out to get you because he is bumping up the asking prices by 10%, it also means that he has to pay 10% more to be able to buy new shares. For the market maker, it is a constant negotiation every second of the day in the stocks they have responsibility for.