What is a Market Maker and How do They Make Money
Have you ever stopped to wonder how it's possible to buy or sell a stock at a moments notice? The speed and simplicity at which it can be done is easily taken for granted. Place an order with your broker, and within seconds, it is executed. To understand why you should be amazed, take a look of what's needed when an order is placed with a broker.
Whenever an investment is bought or sold, there must be someone on the other end of the transaction. If you wanted to buy 1,000 shares of Disney, you must find a willing seller, and visa versa. It's very unlikely you are always going to find someone who is interested in buying or selling the exact number of shares of the same company at the exact same time. This begs the question, how is it that you can buy or sell anytime? This is where a market maker comes in.
What Is a Market Maker?
A market maker is a bank or brokerage company that stands ready every second of the trading day with a firm ask and bid price. This is good for you, because when you place a market order to sell your 1,000 shares of Disney, the market maker will actually purchase the stock from you, even if he doesn't have a seller lined up. The same process happens when placing a market order to buy shares of stock. In doing so, they are literally "making a market" for the stock. Without market makers, it would take considerably longer for buyers and sellers to be matched up with one another, reducing liquidity and potentially increasing trading costs as it became more difficult to enter or exit positions.
How Do Market Makers Make Their Money?
Market makers must be compensated for the risk they take. What risks? What if he buys your shares of common stock in IBM then IBM's stock price begins to fall before a willing buyer has purchased the shares? To prevent this, the market maker maintains a spread on each stock he covers. Using our previous example, the market maker may purchase your shares of IBM from you for $100 each (the ask price) and then offer to sell them to a buyer at $100.05 (the bid price). The difference between the ask and bid price is only $.05, but by trading millions of shares a day, he's managed to pocket a significant chunk of change to offset his risk.
To learn more about how Wall Street works, including some of the things that drive stock prices to the extremes of overvaluation and undevaluation, read Introduction to Wall Street. By taking you through those topics in a step-by-step way, my hope is that by the time you've finished reading it, you'll have a better understanding of some of the forces at work in the capital markets.