What is a Market Maker and How do Market Makers Make Money

• By Blogger
• 5 March, 2013
• 1 Comment

What is a Market Maker?

You probably take for granted that you can buy or sell a stock at a moment’s notice. Place an order with your broker, and within seconds, it is executed. Have you ever stopped to wonder how this is possible? 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.
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 an order to sell your thousand shares of Disney, the market maker will actually purchase the stock from you, even if he doesn’t have a seller lined up. In doing so, they are literally “making a market” for the stock.

How do Market Makers make their Money?

Market Makers must be compensated for the risk they take; what if he buys your shares 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 (bid). 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.