What Does a Market Maker Do, Anyway? It’s about Bridging the Gap

What Does a Market Maker Do, Anyway? It’s about Bridging the Gap

Key Takeaways

    Market makers are intermediaries—professional traders paid to take risk and provide liquidity to the market

    Market makers engage in arbitrage, using proprietary algorithms and mathematical models

    The competing objectives of market makers, institutional players, and retail traders can make for a vibrant, competitive marketplace

So, you’ve done your research, logged in to the trading platform, lined up that trade … and you hit the green buy button. A second later you’re filled—at your price, from a penny-wide bid/ask spread.

That was easy. Too easy, maybe? After all, you know what they say about the deal that was too easily agreed to. 

Not to worry; that’s by design. It’s part of what makes modern capital markets liquid, tight, and dynamic. And at the heart of it all lies the market maker.

What is a market maker, and what do they do?

“Market maker” sounds mysterious, even magical or all-powerful like a puppet master, the proverbial kid-with-the-answer-sheet, or the “person behind the curtain” in the classic movie fantasy. Who’s behind the curtain? Who takes the other side of your trade? And why are they willing to do it? After all, if you’re placing a trade that you see as being a winner, why would someone else want to take the “losing” side?

Let’s unpack this a bit. At any given point in time, there may be any number of other market participants—traders and investors just like you—as well as money managers, institutional investors, and hedge funds buying and selling. 

Investing for retirement or a large purchase down the road? You might be buying stock. Or you might buy a fund, and that fund manager invests in the stock. On the other side, a professional money manager might be selling that stock to rebalance a portfolio, or as part of a long/short relative value trade. A retiree might be selling a few shares each month to meet basic expenses.

And although any of these participants might be motivated to sell to you, it’s unlikely they’re doing it right then, at exactly your price and quantity. That’s where the market maker comes in.

Market makers aren’t all-powerful wizards. They’re just doing their job as intermediaries—professional traders who are paid to take risk and provide market liquidity to make it easier for retail and institutional traders to enter and exit trades. In short, market makers bridge the gap between natural buyers and natural sellers.

The market maker’s toolkit: Models, algorithms, arbitrage, and lots of capital

With stocks, market makers fill orders at the existing quote, which is the bid and ask set by the public as they send in orders. With options that have existing orders, these public orders also set the bid and ask. But in a world where many, maybe most, options do not have public orders in place, market makers need to set the quote. So how do market makers decide where to place bids and offers? To answer, it’s important to first understand the concept of arbitrage. Arbitrage is the rapid-fire buying and selling of the same (or similar) things across venues and markets to capture and close up price inefficiencies. When the prices of two or more related securities fall out of line, arbitrageurs buy and sell until the relationship gets back in line. These price relationships are determined with the help of proprietary algorithms, mathematical models, and software. 

However, with stock trading, they generally do not do this. Instead, as market makers and exchanges receive public limit orders to buy and sell, the bids and offers are set not by market makers, but by the public as they send in limit orders in an attempt to buy a bit lower or sell a bit higher.

Now consider there are dozens of market makers—hundreds in some markets—competing at any given point in time. It’s easy to see why today’s markets are typically tight, deep, and liquid. Here are a few types of arbitrage used by market makers to keep things in line:

    Index arbitrage. The buying and selling of baskets of stock versus the components of an index, such as the S&P 500®, to help keep those prices in lineFixed income arbitrage. Market makers and dealers who buy and sell bonds against those of similar ratings and risk profiles to keep interest rates in line (adjusted for relative risk profiles)Volatility arbitrage. Option market makers using theoretical options pricing models to gauge the relative value (and levels of implied volatility) of options across strike prices and expiration dates

If you want to see market maker arbitrage in action, one good place to look is in the options markets. You can see relative value in each option chain on the thinkorswim® platform (see figure 1). 

What Does a Market Maker Do, Anyway? It’s about Bridging the Gap

FIGURE 1: OPTIONS PRICING: IT’S ALL RELATIVE. Volatility arbitrage helps keep options prices in line with each other. Source: the thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.

A big trade in one of these strike prices might impact the market in and of itself. But market makers running volatility arbitrage programs can spread their risk from this trade across other strikes, related products, and shares of the underlying stock to hedge the risks. These and other hedge trades can help cushion the blow of any one large order and keep prices in line.

Market making strategies: They’re all about the math

It all comes down to market maker tactics and market making strategies and how they may differ from those of retail traders. At the base level, both have the same objectives: maximizing returns and managing risks. How they go about it can differ. 

For example, option market makers use theoretical pricing models to determine probabilities given certain inputs, such as days to expiration, price of the underlying, interest rates, and volatility measures, to determine a theoretical value of an option. 

A market maker who can buy below and sell above theoretical value can, over time, come out ahead. An option market maker who may be trading, at any given point in time, hundreds or even thousands of different strikes in a number of stocks isn’t focused on the individual trade, but rather the mathematical advantage that market makers call “edge.” If they can consistently collect edge from individual trades, they can, over time, and with prudent risk management, “actualize the theoretical.”

Another market maker technique: Inventory risk management

When market makers manage positions, it’s not all that different from any business owner storing stockpiles of a product. Think of a farmer who has a lot of corn to sell. Farmers don’t know exactly where the price will be when it’s time to sell, but they can hedge that price risk using another type of derivative—futures contracts that lock in a sales price. 

Market makers don’t know what the price of anything will be in the future, either. But they use trade data from across markets to help set fair prices for where they’d be willing to buy or sell at any given point in time. And in the process of making markets and taking the other side of order flow, they accumulate inventory. They often use stock, options, futures contracts, or other derivatives to help them manage risk.

That’s right. The person on the other side of your order doesn’t have all the answers. Market makers are professional traders who might think about their positions a little differently than a retail trader or investor might. It’s that different way of thinking—and different motivation—that deepens markets for all who use them.

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