Quick definition A market maker is a trader or firm that quotes prices at which it is willing to buy and sell a security. By standing ready to trade at these quoted prices, market makers provide liquidity to the market. What it is Market makers continuously post bid and ask quotes, promising to buy at the bid and sell at the ask in specified quantities. For example, a market maker might quote "bid 100.50 for 100,000 shares, ask 100.51 for 100,000 shares". Anyone can hit that quote and trade with the market maker. Market makers make profit from the spread: they buy at the bid and sell at the ask, pocketing the difference. They also take directional risk by holding inventory. Why it matters Market makers are essential to liquid markets. Without market makers, every trade would require finding another willing counterparty. Market makers bridge the gap between buyer and seller, always present to provide a price. The quality of market making determines the cost of trading. If competition among market makers is strong, spreads are tight. If few market makers participate, spreads widen. Market Maker versus Floor Trader In modern electronic markets, all market makers operate electronically via algorithms. The old image of a trader shouting on a trading floor is outdated. Modern market makers submit orders electronically and manage their inventory through automated systems. Practical example A market maker in Apple quotes bid 150.40 / ask 150.41. A buyer hits the ask and buys 10,000 shares at 150.41. The market maker now owns 10,000 shares (is long inventory). A seller then hits the bid and sells 8,000 shares at 150.40. The market maker is still net long 2,000 shares. If the price moves to 150.50, the market maker has gained 0.10 dollars per share on the 2,000 share inventory. If the price moves to 150.30, the market maker has lost 0.10 dollars per share on that inventory. Inventory management Market makers must manage their inventory to avoid excessive exposure to price risk. If they accumulate too much long inventory, they widen their ask prices to encourage selling. If they accumulate too much short inventory, they widen their bid prices to encourage buying. Regulatory environment Market makers operate under regulations that require them to maintain fair and orderly markets. In the US, Regulation SHO imposes short-sale restrictions. In some markets, market makers receive rebates for providing liquidity. See also - Bid-Ask Spread - Liquidity - Inventory Risk - Adverse Selection
