There’s a secret corner of the trading world where market makers (MMs) hide and thrive.
You’ve likely heard of them. You might have seen the effects of their work — stocks moving in ways you couldn’t understand.
In this post, I’ll pull back the curtain on market makers. You’ll get a close look at who they are, how they make a living, and how they impact the market.
Before the internet, it was harder to find them. Now, if you study Level 2 hard enough, you’ll be able to find clues that they’re around.
They work behind the scenes at some of the largest financial firms in the country. But what do they actually do? And does it help everyday traders or hurt them?
Let’s uncover the mystery of market makers’ methods in today’s post.
Table of Contents
What Are Market Makers?
Most work for large firms. Brokerage firms, investment firms, and stock exchanges hire them to keep markets moving. They can also work independently.
An MM adds to the volume in the market by placing large orders for specific stocks or bonds. The more volume in the market, the better the stock liquidity for traders. Market makers take their cut from differences in the bid-ask spread.
It may sound like an easy job. In reality, there’s a lot of stress involved, and how the market maker manages it determines how far ahead they get. Now, that’s something retail traders and market makers have in common.
It’s a delicate balance. There’s always risk biting at the market makers’ heels. They could fill an order while the price moves against them in nanoseconds. If they keep losing profits, they’ll also lose their seat at the firm’s desk.
But they can’t play it too safe, either. If a firm sees they’re unwilling to take risks on a particular stock, it’ll pass it on to another market maker who will.
Market makers sometimes manage a few hundred stocks at once. They keep track of their bid-ask spreads, their position sizes, and their total capital.
Think about that the next time you want to complain that the market’s too hot to handle. Or that your watchlist has grown to the size of a football field.
Speaking of watchlists, have you signed up for my weekly watchlist yet? It’s a list of my best picks to watch in the week ahead. And there’s no cost to get it delivered right to your inbox.
Broker vs. Market Maker: What’s the Difference?
There are a lot of players in the game of financial transactions. Sometimes it’s hard to know who does what. But you should know the difference.
It helps to know what goes on behind the scenes. You want to know who’s moving the markets when you’re trying to trade. Here are a couple of key players and what they do…
Brokers
Brokers facilitate transactions. They have the authority and expertise to buy securities on an investor’s behalf.
There are a variety of brokers that offer premium and discount services. Most brokers allow both long positions and short positions. But if you want to short, it’s wise to pick a broker with expertise in managing borrows.
Brokers also have different rules for what they’ll make available to traders and investors. While most brokers allow trading listed stocks, some restrict penny stocks and cryptocurrency.
The world of brokerage firms is always changing. Only recently did Robinhood force other brokerage firms to adopt commission-free trades. They had to if they wanted to compete. Now you can get the same deal at E-Trade, Charles Schwab, TD Ameritrade, Webull, and more.
Market Makers
MMs belong to large banks or financial institutions. They provide liquidity in the markets by placing large volume orders. They both buy and sell securities.
When there’s low liquidity in the markets, traders get stuck in their trades. No one will buy their shares from them. Sometimes traders want to buy a stock but their orders won’t get filled.
Market makers must buy and sell orders based on the price they quote. They can’t change their minds the way a trader can. The prices they set reflect the supply and demand of stocks and traders.
Sometimes a market maker can also act as a broker. But doing so incentivizes them to recommend their firm’s stocks. As you can imagine, this is a conflict of interest.
Always choose a broker that keeps their duties as a broker and a market maker separate. So who are the biggest market makers?
In the internet age, it’s not hard to find a market makers list if you want to. Some of the biggest market makers are names familiar to most retail traders — Morgan Stanley, UBS, Deutsche Bank…
Who Are the Market Makers?
They serve in a variety of roles. So they can work in-house at a major investment firm or independently.
Many exchanges use market makers who compete to set the best bid or offer. They want to win the orders that are coming in. This keeps bid-ask spreads liquid but also at a fair price for traders and investors.
There’s an exception to this system. The New York Stock Exchange (NYSE) employs a “specialist” system. That means they use a lone market maker with a monopoly over the order flow in a particular security.
The specialist sets the opening price for a stock when the market opens. And it’s based on supply and demand. Their job is to post incoming bids and asks from traders on time as they come in.
Types of Market Makers and What They Do
Market makers must buy and sell at the National Best Bid and Offer (NBBO). They must post and follow through with their bid and ask quotes. These are for the stocks that they make a market in.
Market-making firms come in three categories. We’ll get into what each is responsible for below…
Retail Market Makers
These market makers work at retail brokerage firms. When retail traders place orders, they work to keep stocks liquid. They make prices more efficient to keep order flow moving. But they also profit from the bid-ask spread. Even with commission-free trades, brokers get their cut.
Institutional Market Makers
These market makers work on large block orders for mutual funds. They also work for pension funds, insurance companies, and other asset management firms. Institutional market makers must have lots of capital inventory available to the markets. They have this in common with retail market makers.
Wholesalers
These market makers trade securities for both institutional clients and broker-dealers. They focus on high-volume pools (sometimes called dark pools). They can use high-frequency trading algorithms to create optimized bundle orders.
And they use order flow arrangements. This means they pay brokerages to direct customer orders their way.
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How Do Market Makers Make Money?
They run the bid-ask spread and profit from the slight differences in the transaction. They establish quotes for the buy and sell prices. And these are slightly different from the natural market prices.
The spreads between the prices a retail trader sees in bid-ask quotes and the market price go to the market makers. MMs move fast and can buy and sell in bulk ahead of everyone else.
This helps the flow of trading when things get stuck. But it also gives market makers much more power than the average retail trader in a transaction.
Market makers also earn commissions from their firms for providing liquidity.
How Much Do Market Makers Make?
According to Zippia.com, the average salary for a market maker in the U.S. is $96,909 per year. That comes out to about $47 an hour. Pretty good, right?
The top 10% of market makers earn over $172,000 per year. And the bottom 10% earn under $54,000 per year.
Of course, some MMs have insider connections. And they can really help grease the wheels.
We talked to a former market maker on the SteadyTrade podcast. He regularly made seven figures! Even the market makers below him made seven figures a month.
Hear him talk about his heyday of market making on one of our most-watched episodes to date. You’ll never look at the markets the same way again.
Can Market Makers Lose Money?
Yep. The market makers’ method gives them an advantage in the markets. But they still have to stay on their toes.
Markets move fast. Prices fluctuate. Despite MMs’ best efforts, sometimes assets lose value in the blink of an eye.
An MM can lose money when a security declines after they’ve bought it. If they don’t sell it fast enough. Sometimes the bid-ask spread shortens faster than expected.
They also risk losing money when they don’t have the latest information on a stock. Every trader has to receive and respond to information quickly to gain a trading edge.
MMs use more size and capital than the average trader. It only takes a few seconds for a position to go against them. That’s why so many rely on algorithms to stay ahead of the curve.
Why Is Market Making Important?
Market makers help keep markets efficient. They also provide liquidity. Their large orders keep markets flowing. If their orders stopped, it’d be harder for traders to get in and out of their trading positions.
When a bid-ask spread is too wide, liquidity is low and volatility is high. Nobody wants that. Market makers step in to get things moving again.
Have you ever been in a penny stock trade watching the bid-ask spread get wider and wider? It’s frustrating! You can’t get the price you want or get out of the stock. If liquidity is really bad, you can’t even get a market order filled!
How Can Market Makers Manipulate Stocks?
They have access to insider information. And they maintain close relationships with key players at major firms. In other words, they’re in the know and they’ve got connections.
This makes it easier for MMs to manipulate stocks. And when they do, they do it within legal boundaries. Nice work if you can get it, huh?
Here’s an example. If a market maker wants to drive down a stock price, it’s not as simple as shorting a stock. That kind of risk is something we retail traders have to deal with.
Let’s say an MM gets an institutional order to sell two million shares of a stock. That’s a large order, so it’s likely to affect the stock’s price. The market maker knows this ahead of time. So what do they do?
They choose to “work” the order. That means they short the stock in the open market. Then they close that trade by purchasing the institutional sell order. They can place the short order through principal trades or agency trades. Both are legal.
A principal trade is when a brokerage firm fills a customer’s trade with its own inventory. An agency trade is when a brokerage firm finds a counterparty to the customer’s trade. This could be a customer at another brokerage firm.
As a retail trader, you can’t swap trades with your trading buddies like that. But you can do your best to stay on top of the latest news as soon as it breaks.
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Market Makers: The Bottom Line
Love ‘em or hate ‘em, MMs are an essential part of the stock market. And their job is not as easy as it looks. They juggle more stocks than most of us care to watch. And I say that as someone who loves the grind.
They provide a service: keeping liquidity in the markets. And they get their cut for it. Sometimes they “work” an order to get an even bigger cut.
But does it all come out in the wash? How important is bid-ask spread efficiency? Is there a better way to provide market liquidity? I don’t have the answer! I just share the news.
At the end of the day, traders are making great gains with the market we have today. And that’s something I’m grateful for.
Of course, you have to keep your eye on those guys. You don’t want to get stopped out of a trade only to see the stock take off right after.
That’s why you have to put your screen time in. Get a feel for how markets move. Ask yourself what natural momentum looks like. Study Level 2 price action.
You’ll get the hang of it. At some point, it all becomes a fun game of cat and mouse. With some precious tendies on the line, of course.
Are we better off without MMs or do they provide a useful service? Have you been stuck in a manipulated stock or an illiquid stock? Leave a comment!
