Market Middlemen


  • Market makers “buy” stocks from sellers at a slightly lower price (bid price) and “sell” them to buyers at a slightly higher price (ask price). This small difference between the two prices is called the spread, and that’s how they make money

Example

A market maker can potentially earn 215.39) and sell at the ask price (48.

Reward comes with risk

The higher the spread, the higher profit the market maker can make.

Algorithmic and operational risks

Market makers rely on sophisticated algorithms to set prices and manage orders across multiple securities. Errors in these systems (e.g., faulty code) can lead to significant losses, as seen in cases like Knight Capital’s $460 million loss in 2012 due to a software glitch.

Stock Inventory


  • Market makers maintain a stockpile of shares. If a seller wants to sell but no buyer is willing to pay the seller’s price, the market maker buys those shares. Later, when a buyer comes along, the market maker sells the shares to them

Inventory risk

Market makers maintain inventories of securities to facilitate trades. If they accumulate too much of a security (long position) or sell too much (short position), they are exposed to price fluctuations.

For instance, if they hold a large inventory and the market price drops significantly, they incur losses.