subject: What Is Market Making [print this page] Market making is the process of quoting bid and ask prices to earn a profit on the difference between the bid and ask prices (bid-ask spread or bid-offer spread). The bid price is the price that market maker is willing to pay for a security, where the ask price is the price at which the market maker is willing to sell the security. The spreads are determined by factors such as the liquidity of the security market makers widen the spread for illiquid securities i.e. when theres a risk that a security that was bought by a market maker can be sold for less than the bid price therefore resulting in a loss. An important function of a market maker (besides making money) is therefore the provision of liquidity in the market without it clients may not be able to immediately buy/sell a security they want.
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Market making facilitates trading in a security to meet an order for a customer. In this case the bid-ask spread is the transaction cost. For example, a market maker buys a security from you for $20 (bid) and will immediately seek to close the position by offering to sell (ask) for $20.5. Obviously, the larger the position, the larger the potential profit (or loss). The size of the spread also affects the profits earned by the market maker. A large spread means a larger profit, although a smaller spread may mean larger volumes it is, in a sense, a trade-off. Market makers are not immune from price competition and may undercut each others spreads.
There are different theories as to how market makers set their spreads. An excellent summary can be found in The Effect of Risk on the Market Makers Spread by A. Barnea and D. Logue (available from JSTOR). Some of the findings are as follows:
1.
1. Liquidity Theory
2. a. bid-ask spread is positively related to average price of security and total number of stocks handled by the trader
3. b. the spread is inversely related to the securitys volume, competition faced by the market maker and number of institutional investors holding the security.
4.
1. B-T Theory
1. a. the more inherently risky the security, the greater the spread. One such risk is the marketability risk i.e. the higher the volume of a traded security, the easier a market maker can liquidate a position, therefore, lowering the spread.
Most of the time, the transactions entered into by the market maker do no perfectly offset each other and the market maker ends up holding the security for a period of time. Consequently, if a market maker enters a transaction that creates a long exposure, he/she will seek to hedge the risk by short selling the security to achieve and maintain a delta neutral position. A delta neutral position basically means that the position of the trader is not sensitive to changes in price of the underlying asset (delta measures sensitivity of the options price to change in the price of the underlying security), where delta is close to 0. Positions can be also offset by synthetic equivalents, for instance, shorting a stock can be recreated by a short call and a long put[1]. Overall, the hedging strategies used are determined within each institution in a framework allowed by regulators at the time for example short selling bans (Note: the recent short selling ban in Germany actually exempts market makers and is targeted towards speculators)
Options market makers additionally face risks specific to option pricing i.e. components of the Black-Scholes model. These include volatility risk (Vega risk), time decay risk (Theta), interest rate risk (Rho) as all of these factors can change the options price and therefore affect the traders position.
In a market making situation, the trader acts as a broker for a client as opposed to prop (proprietary) trading, whereby the trader buys and sell securities for the firms account rather than for a client aiming to buy low and sell high. Market making is exempted in the recently amended version of the Volcker rule, however, the line between market making and prop trading is often blurred.
