April 13, 2012/ Taiwo Ologbon-Ori / Proshare Research
In this article, Taiwo provides an explanation to some of the questions and concerns received from the investment community last week.
1. Market Maker – In simple English
2. What Happens If There Are No Market Makers?
3. How Does Market Makers Make A Profit?
4. What is the difference between a broker and a market maker?
5. The Basics Of The Bid-Ask Spread
Supply and Demand
Example - How Supply and Demand Work Together
Example - The Bid-Ask Spread
The Market-Maker is a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. .i.e. the company must stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price.
In advanced market/exchange, they are widely used in one form or another as liquidity providers, stabilizers and order managers of the market.
The rest of market participants are therefore guaranteed to always have counterparty for their transactions. This renders markets more orderly and prices less volatile. Market-makers are remunerated for their services by being able to “buy low and sell high”.
Instead of a single price at which any trade can occur, dealers quote two prices – a “bid” (dealer’s purchase, customer’s sale) and an “ask” (dealer’s sale, customer’s purchase). The ask is higher than the bid, and the difference between the two is called the spread – the dealer’s source of revenue.
Ordinarily, Market-makers make money in both rising and falling markets, by taking advantage of the difference between "bid" and "offer" prices. A market maker aims to make money by buying stock at a lower price than the price at which they sell it, or selling the stock at a higher price than they buy it back.
In a layman's language
Many investors ask, who is buying from me when I am selling and who is selling to me when I am buying? What happens when nobody wants to buy a stock or stock option which I am selling?
In a normal, liquid market, there are usually someone queuing to sell a stock when you are buying and someone queuing to buy when you are selling. However, there are times when nobody is queuing to sell when you are buying and times when nobody is queuing to buy when you are selling, so, how is it that you are still able to buy or sell your stocks smoothly? This is where Market Makers come in.
A "Market Maker" can be an individual or representatives of a firm whose function is to aid in the making of a market in an stock exchange, by making bids and offers for his account in the absence of public buy or sell orders in order to ensure market transactions are as smooth and continuous as possible.
When a stock trader places an order to buy a stock which nobody is queuing to sell, market makers sell that stock to that stock trader from their own portfolio or reserve of that particular stock. When a stock trader places an order to sell a stock option which nobody is queuing to buy, market-makers buy that stock from that trader and adds it to their own portfolio and reserve. In doing so, market orders are continuously moving, eradicating sudden surges and ditches due to buying and selling imbalance.
In the Market Maker System, many market-makers are assigned to every security. As every Market Maker effectively acts as a "Specialist" like in other advanced markets, there are effectively many specialists for each stock. This creates a decentralised market place where liquidity and volatility varies. This improves overall liquidity and makes market manipulation much more difficult.
What Happens If There Are No Market Makers?
Let's see what happens when we remove market makers from the markets.
XYZ stock is an extremely bullish stock who has just announced impressive earnings. You want to buy XYZ stocks but investors who are already holding XYZ stocks are not selling. In order to attract a seller, you begin to bid higher and higher for XYZ stock until at last, a seller is moved to selling the stock. This price could already be extremely high.
Consider again a sudden bad news released from XYZ company, creating a rush to sell XYZ stocks. You are queuing to sell but nobody is buying. In order to attract a buyer, you start to push the price lower and lower until at last, the price bottoms out worthless.
As we have seen, in an imbalanced buying and selling situation, market makers play an extremely important role of creating liquidity for prices in between in order to eradicate huge gap ups and downs and to ensure a liquid market for all.
How Does Market Makers Make A Profit?
Market Makers are not paid commissions to buy and sell stock, so how do they make a profit?
Well, most institutional market makers simply earns a salary from the firm that they represent. Market Maker firms like Goldman Sachs and Morgan Stanley, commit their own capital to maintain an inventory of stocks and represent customer orders.
On the trading floor, market Makers make money by maintaining a difference between the price he would buy and the price he would sell a particular stock or stock option. This difference in price is known as the Bid-Ask Spread. A bid-ask spread ensures that if an order to buy and an order to sell arrives simultaneously, the Market Maker makes the difference in Bid-Ask Spread as profit.
Example: XYZ has a bid price of N1.10 and an ask price of N1.30. Market Maker John receives simultaneously an order to buy and an order to sell. Market Maker John buys that XYZ from the seller for N1.10 and then sells that same XYZ option to the buyer for N1.30, thus making N0.20 in profit completely risk-free.
However, when a Market Maker is not confident that a stock can be so quickly bought and sold, due to the fact that there are only very few stock traders trading that security, then there is a risk that a stock which that Market Maker buys can only be sold when the market price is lower than the prevailing price, therefore resulting in a loss.
In order to protect against such a risk, Market Makers, widen the bid-ask spread so that the transaction remains risk free to him over a larger price range. Also, there are other ways of making profit but they are not meant for this context.
What is the difference between a broker and a market maker?
A broker is an intermediary who has a license to buy and sell securities on a client's behalf. Stockbrokers coordinate contracts between buyers and sellers, usually for a commission. A market maker, on the other hand, is an intermediary that is willing and ready to buy and sell securities for a profitable price.
A broker makes money by bringing together securities' buyers and sellers. Brokers have the authorization and expertise to buy securities on an investor's behalf - not just anyone is allowed to walk into the Stock Exchange and purchase stocks; therefore, investors must hire licensed brokers to do this for them. A flat fee or percentage-based commission is given to the broker for carrying out a trade and finding the best price for a security.
Because brokers are regulated and licensed, they have an obligation to act in the best interests of their clients. Many brokers can also offer advice on what stocks, mutual funds and other securities to buy. Due to the availability of internet-based automated stock brokering systems, clients often do not have any personal contact with their brokerage firms.
A market maker makes a profit by attempting to sell high and buy low. Market makers establish quotes whereby the bid price is set slightly lower than listed prices and the ask price is set slightly higher in order to earn a small margin. Market makers are useful because they are always ready to buy and sell as long as the investor is willing to pay a specific price.
This helps to create liquidity and efficiency in the market. Market makers essentially act as wholesalers by buying and selling securities to satisfy the market; the prices they set reflect market supply and demand. When the demand for a security is low and supply is high, the price of the security will be low. If the demand is high and supply is low, the price of the security will be high. Market makers are obligated to sell and buy at the price and size they have quoted.
The Basics Of The Bid-Ask Spread
You've probably heard the terms spread or bid and ask before but you may not know what they mean or how they relate to the stock market. The bid-ask spread can affect the price at which a purchase or sale is made - and an investor's overall portfolio return. What this means is that if you want to dabble in the equities markets, you need to become familiar with this concept.
Supply and Demand
Investors must first understand the concept of supply and demand before learning the ins and outs of the spread. Supply refers to the volume or abundance of a particular item in the marketplace, such as the supply of stock for sale. Demand refers to an individual's willingness to pay a particular price for an item or stock
Example - How Supply and Demand Work Together
Suppose that a one-of-a-kind diamond is found in the remote countryside of Africa by a miner. An investor hears about the find, phones the miner and offers to buy the diamond for $1 million.
The miner says she wants a day or two to think about it. In the interim, newspapers and other investors come forward and show their interest. With other investors apparently interested in the diamond, the miner holds out for $1.1 million and rejects the $1 million offer. Now suppose two more potential buyers make themselves known and submit bids for $1.2 million and $1.3 million dollars, respectively. The new asking price of that diamond is going to go up.
The following day, a miner in Asia uncovers 10 more diamonds exactly like the one found by the miner in Africa. As a result, both the price and demand for the African diamond will drop precipitously because of the sudden abundance of the once-rare diamond. This example - and the concept of supply and demand -can be applied to stocks as well.
The spread is the difference between the bid and ask for a particular security.
Example - The Bid-Ask Spread
Let's assume that Stanbic-IBTC wants to purchase 1,000 shares of XYZ stock at N10.00, and Renaissance Cap wants to sell 1,500 shares at N10.25. The spread is the difference between the asking price of N10.25 and the bid price N10, or N0.25.
An individual investor looking at this spread would then know that if he wants to sell 1,000 shares, he could do so at N10 by selling to Stanbic-IBTC. Conversely, the same investor would know that he could purchase 1,500 shares from Renaissance Cap at N10.25.
The size of the spread and the price of the stock is determined by supply and demand. The more individual investors or companies that want to buy, the more bids there will be; more sellers results in more offers or asks.
It is important to note that when a firm posts a top bid or ask and is hit by an order, it must abide by its posting. In other words, in the example above, if Stanbic-IBTC posts the highest bid for 1,000 shares of stock and a seller places an order to sell 1,000 shares to the company, Stanbic-IBTC must honour its bid. The same is true for ask prices.