A market participant who is always in the market but very less noticed. So who are market makers, what’s their role, why they are so important in our market, and how do they help us in our day-to-day trading.
Let’s start basic understanding of who are the market makers?
Market makers are the firm or individuals appointed by the stock exchange who actively quote two sides of the market in a particular security in the market, by providing the bid and offer along with the market size of each.
Market makers provide liquidity and depth to the market and profit from the difference between ask and offer
Many market makers are often brokerage houses that provide services to traders & investors. Their function makes or keeps the market in a highly liquid state.
So what’s the role of a market maker?
Why are they so important for trading markets?
Every stock or security needs a market of buyers and sellers to move on to the exchanges. So whenever security is bought or sold, there must be someone on the other end of the transaction. Let’s take a hypothetical example we want to buy 100 shares of reliance we need to find someone willing to sell the 100 shares of reliance. However, it is unlikely that we will find someone immediately who wants to sell the exact amount of shares we want to buy. This is where the market maker’s role comes in. Market makers are high-volume traders who literally "make a market" for the securities by always standing ready to buy or sell.
In short, the market maker provides liquidity, the framework that reduces the time required to execute the trade and cost of transitioning, allowing large quantities of security to trade freely. Which ultimately leads to the smooth functioning of the markets.
Why market makers are so important in today’s market?
The speed and simplicity with which stocks are bought and sold can be taken for granted, especially in the era of in-app trading. It takes just a few taps to place an order with your broker, and depending on the type of order, it can be executed within seconds. Without market makers, however, trading would slow down significantly. Which will ultimately cost traders and reduce the efficiency of the market. So in today’s era, we need market makers most than anytime before.
As we are progressing towards technology advancement, the tasks which were executed by humans are now performed by algorithms, because there are limitations on how fast humans can act, compared to machines. This also introduces liquidity in hedging derivatives and reduces the impact cost.
How does the market maker make money?
Lastly, if you have a doubt that do these market makers make money or they are just serving to make markets more efficient. It's obvious that they are here to make money like other participants.
When an entity is willing to buy or sell shares at any time, it adds a lot of risk to that institution's operations. For example, a market maker could buy your shares of common stock in reliance just before reliance's stock price begins to fall. The market maker could fail to find a willing buyer and, therefore, they would take a loss. That's why market makers want compensation for creating markets. They earn their compensation by maintaining a spread on each stock they cover.
For example, consider a hypothetical trade of reliance shares. A market maker may be willing to purchase your shares of reliance from you for ₹100 each—this is the bid price. The market maker may then decide to impose a ₹0.05 spread and sell them at ₹100.05—this is the asking price. The difference between the ask and bid price is only ₹0.05, but the average daily trading volume for reliance is more than 6 million shares. If a single market maker covered all those trades and made 0.05 for each one, they'd earned more than ₹3,00,000 every day.
Key takeaways:
A market maker is an individual participant or member firm of an exchange that buys and sells securities for its account.
Markt makers create a market with liquidity and depth while profiting from the difference in the bid-ask spread.
Brokerage houses are the most common types of market makers, providing purchase and sale solutions for traders & investors.
Market makers are compensated for the risk of holding assets because a security's value may decline between its purchase and sale to another buyer.
Without market makers, far fewer trades would happen and companies would have more limited access to capital.
Market makers profit on the difference between the bid and ask prices on their trades.