What Is a Market Maker?
Market maker is a firm that continuously quotes both a price at which it will buy and a price at which it will sell, profiting from the difference between the two. Its business is transaction volume rather than market direction, and the spread it quotes is the cost the other side pays.
A market maker stands ready to buy from anybody selling and sell to anybody buying, at prices it posts in advance. That single obligation explains both why markets are liquid and why trading costs what it does.
How it works
It posts two prices. A bid, at which it will buy, and an ask, slightly higher, at which it will sell - both visible to everybody, both live.
The difference between them is the spread. If it buys at the bid from one seller and sells at the ask to one buyer, it has earned that difference without taking a view.
Its income scales with turnover. A thousand small round trips at a narrow spread is the business; a correct opinion about next month is not.
What the spread is actually pricing
The market maker is exposed between the two legs. It buys now and may not sell for seconds or minutes, and price can move against it in that gap.
So the spread is compensation for that exposure. More volatile instruments carry wider spreads because the inventory risk between legs is larger.
And it also prices being wrong about who is trading. Some of the flow arriving is better informed than the quote, and the spread has to cover the losses to that flow out of the profits on everybody else.
A worked example
Take a bid of 99.99 and an ask of 100.00. A buyer pays 100.00, a seller receives 99.99, and the market maker collects the penny in between for standing there.
On this site’s shared series the round trip costs 0.0098, about 2% of a median bar range of 0.493. That is the same thing measured from the other side.
Fifty round trips pay that fifty times. The market maker did nothing different on any of them; the total is set entirely by how often the other side chose to transact.
Which is where the useful lesson sits. The cost of the spread is not something done to you - it is something you decide the size of, by deciding how often to trade.
Who they are and how they are paid
Some are designated by an exchange. Formal market makers accept an obligation to quote continuously in a named instrument, and receive fee rebates or privileges in return.
Others are simply high-volume firms. They provide liquidity because the spread is profitable, with no obligation to continue, and can stop quoting when conditions turn.
Retail brokers often route orders to wholesalers. A wholesaler pays the broker for the flow and fills the order itself, which is how commission-free trading is funded.
That arrangement is disclosed rather than hidden. Brokers publish routing and payment reports, so whether your flow is sold is a fact you can look up rather than a theory.
What widens a spread
Volatility widens it. The more price can move between the two legs, the more the quote has to charge for standing in between.
Thin volume widens it. If the second leg may take hours to find, the inventory is held longer and the risk is larger.
News widens it, and sometimes removes it. Around a scheduled announcement the quote can vanish entirely for a moment, because no price is safe to post until the number is out.
And size widens it beyond the screen. The displayed quote covers a certain number of shares; an order larger than that walks up the book, paying progressively worse prices, which is a wider effective spread than the one you were shown.
The original data
On this site’s shared series: median bar range 0.493, ninetieth percentile 1.101, largest bar 2.338. Direction runs average 2.01 bars with a longest of 11. A round trip costs 0.0098, about 2% of the median bar range.
That 2% is the market maker’s side of every trade you make. It is small per trade and it is charged per trade, which is a very different thing from being small in total.
And the fee-drag measurement shows where repeated small costs end up: on this site’s figures, 75 basis points a year removes 20.2% of a thirty-year balance. Spread paid on frequent trading is the same arithmetic running faster.
What it means for how you trade
Trade frequency is the lever you control. The spread is charged per round trip, so halving how often you trade halves that cost exactly, with no judgement required.
Liquidity is the filter that matters most. A size floor and a volume floor remove the instruments where the spread is a large share of the move you are trying to capture.
Limit orders change who pays. A resting limit order can be filled at your price rather than crossing the spread, at the cost of sometimes not being filled at all.
And costs belong in the test, not the review. A strategy evaluated without the spread is being judged on a version of itself that nobody can trade, and adding it afterwards changes which strategies were worth running in the first place.
When it fails
The characteristic failure is believing you are being hunted. A market maker’s quote is posted before it knows who will hit it, and it earns the same spread whether the taker is right or wrong.
The real cost is invisible because it is small each time. It arrives as a slightly worse fill, fifty or five hundred times, and never appears as a line item - which is why it is underestimated by almost everybody who trades actively.
A second failure is assuming a quote is a commitment to size. The displayed size is what is available at that price, not what is available at any price.
A third is expecting quotes in a fast market. Liquidity thins exactly when it is most wanted, and voluntary market makers can stop.
A fourth is trading illiquid names on the same assumptions, where the spread can be many times the figure above.
And a fifth is ignoring the spread in a backtest. A system tested at the midpoint is a system that traded with nobody, and on frequent strategies that omission is usually the whole result.
Related
Bid-ask spread covers the number a market maker earns. Liquidity covers what their quoting provides. And order book covers where those quotes are displayed.
A lot of retail trading folklore treats these firms as adversaries hunting individual stops. The honest version is less dramatic and more useful: they make money on how often you trade, not on whether you are right. That changes what you should worry about - not being targeted, but trading often enough that the spread becomes the largest line in your results.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.