What is market making, and how it’s affect liquidity?

What is market making? Market making is basically creating a market for a particular product or asset. This means that if someone wants to sell the product, you would buy it from them, and if someone wants to buy the product, you would sell it to them.

Do you remember the concept of order books? a book represent all the buyers and sellers for that stock.

Imagine a scenario where there are no buyers or sellers present in the order book for a stock. No one has placed an order to either buy or sell the stock.

In such a situation, if you wanted to sell that stock, there would be no one available to purchase it. Consequently, there would be no active market for that stock.

As we discussed earlier, we highlighted the importance of having a market. This creates an opportunity for a specific role that is essential for facilitating the market and ensuring liquidity: The market maker.

A market maker is an individual or entity that consistently provides bids and offers on the market. This ensures that if a trader wishes to buy or sell a particular stock, there will always be someone available to engage in the transaction.

To become market makers, individuals or entities were required to register with the exchange. Once registered, they gained the privilege of buying and selling securities throughout the trading day at lower commissions.

Market makers specialized in a select number of stocks, engaging in continuous buying and selling activities. Multiple market makers operated in the market for each stock. This arrangement was beneficial for both companies and investors as it ensured the presence of a consistently active market.

What motivates individuals or entities to become market makers? What are the benefits they can gain from taking on this role?

The primary motivation for individuals or entities to become market makers is to generate profits.

Example:

Consider this example of an order book.

BUYERSSELLERS
1000 @ $105000 @ $11
2000 @ $910000 @ $12
2000 @ $81000 @ $15
1000 @ $7
1000 @ $6

The goal of market makers is to purchase a product at the bid price and sell it at the ask price.

Let’s take this example with a bid price of $10 and an ask price of $11. Suppose a market maker buys 1000 shares at $10 and immediately places a sell order at $11. If they are able to sell the shares at $11, they would make a profit of $1 per share. In this case, with a thousand shares, they would earn $1000.

The market maker then repeats this process to continue making profits.

As a market maker, the ultimate objective is to maximize profits by engaging in the buying and selling process. In doing so, market makers effectively create and maintain a market for the particular stock.

However, being a market maker entails certain risks. For instance, if a market maker purchases 1000 shares at $10 with the intention of selling them at $11, there is a risk if a substantial seller enters the market and causes the price to decline, consequently altering the bid and ask prices. Let’s assume that the bid decreases to $7 and the ask drops to $8. In such a situation, if the market maker is compelled to sell the shares at $8 after buying them at $10, they would incur a loss of $2 per share. Considering the thousand shares, this would result in a loss of $2000.

Market makers willingly bear the risk associated with their role, understanding that despite occasional losses, they will continue to repeat the process of buying at the bid price and selling at the ask price. Through repeated transactions, they aim to accumulate significant profits over time, even though they may experience occasional losses along the way.

That is precisely what market makers do. The money they earn comes from the spread they create.

In previous discussions, we have gained an understanding of the spread, which represents the price difference between the bid and ask in a market.

By examining the order book, we can observe that the spread in this case is $1. This is calculated by taking the difference between the ask price of $11 and the bid price of $10, resulting in a $1 spread.

BIDASK
1000 @ $105000 @ $11

This is merely an illustrative example. In reality, spreads in stocks are not fixed at a dollar amount like the previous example.

Spreads tend to be much narrower, particularly for highly liquid stocks. Some stocks may have spreads as narrow as 1 cent, while others may have spreads of 10 cents or 50 cents. However, there are rare cases where spreads can be wider, exceeding a dollar or more, but such instances are infrequent.

Market makers generally prefer larger spreads as they have the potential to generate higher profits. With larger spreads, the market maker can capture a greater price difference between the bid and ask prices, resulting in increased profitability per trade.

This leads us to the concept of passive and aggressive market approaches.

Passive and aggressive market approach

active vs passive approach

If you are buying at the bid, you are adopting a passive approach as a buyer. By placing a limit order to buy, despite the absence of sellers at that price, you are patiently waiting for a seller to enter the market and sell to you.

Market makers exhibit a passive approach as they refrain from immediate buying. They place their orders and prefer to wait for a seller to match their desired price, after which they execute the purchase.

Let’s consider the following example.

BIDASK
1000 @ $25.205000 @ $25.30

If you place an limit order at a price of $25.29 or below, you are adopting a passive stance. This is because your order will not be immediately executed upon submission since there are no sellers available at your specified price. so you are waiting, being passive.

On the other hand, if you submit an order at $25.30 or above, you are taking an aggressive approach. This means that you are actively buying the asset immediately at the current ask price, which represents the minimum price at which someone is willing to sell. In this case, you are acting as an aggressive buyer.

If you place a market order to buy, you are displaying an aggressive approach. This is because you are indicating that you are willing to acquire the asset at any available price, without any specific price limit or negotiation.

On the contrary, if you want to sell a stock and you submit a sell order at $25.30, you are adopting a passive stance as a seller. In this case, you are waiting for a buyer to purchase the stock from you at your specified price. Even if you set a higher price than $25.30, you are still considered passive.

If you place a limit order to sell your stock at any price above $25.21, you are maintaining a passive stance as a seller. You are waiting for a buyer to meet your specified price before the sale is executed. The only scenario in which you become an aggressive seller is when you submit a limit order to sell at $25.20 or lower. This is because, at that price, there are buyers actively waiting to execute trades, resulting in an immediate execution of your order.

In every trade execution, there is typically a passive participant and an aggressive participant involved.

This leads us to the concepts of adding liquidity and providing liquidity to the market.

Providing liquidity to the market

We discussed the importance of market liquidity, which is desired by both companies and investors. A liquid market refers to a market where a large number of shares can be sold without significantly impacting the price.

So when you are being passive are actually adding liquidity or removing liquidity from the market?

Consider this scenario

BUYERSSELLERS
20000 @ $10 + 1000 @ $105000 @ $11
2000 @ $910000 @ $12
2000 @ $81000 @ $15
1000 @ $7
1000 @ $6

If you intend to buy 20,000 shares of a particular stock and place a passive order at $10, you have contributed an additional 20,000 shares to the existing 1,000 shares already available on the bid. As a result, there will now be a total of 21,000 shares available for purchase at the bid price.

Now, if a seller enters the market and sells, let’s say, 5,000 shares at the market price (using a market order), their order will be filled at $10. This is because there are buyers willing to purchase a total of 21,000 shares at $10. As a result, the seller will be able to sell all their shares at $10 without causing any significant impact on the stock price.

However, if you were not present and did not place an order for 20,000 shares at $10, the situation would be different. If the same seller entered the market wanting to sell 5,000 shares at the market price, there would only be 1,000 shares available at $10, 2,000 shares at $8, and 1,000 shares at $7. In order to sell all 5,000 shares, the seller would have to continue lowering the price, potentially pushing it all the way down to $6, as there would not be enough passive buyers available to absorb the shares.

Therefore, the absence of passive buyers and sellers in the market leads to decreased liquidity. The presence of more passive participants with open orders on both the bid and ask sides contributes to increased market liquidity. This liquidity enables the market to handle larger orders, such as the previous sell order, without causing significant price impacts.

Whenever you place a passive order, you are actively contributing liquidity to the market. On the other hand, when you submit a market order (aggressive order), you are effectively reducing liquidity in the market.

Market makers always strive to provide liquidity to the markets. but later they replaced by High frequency traders.

It’s important to note that achieving profitability through market making at a retail level is challenging due to high competition and automation in the field. However, understanding market making is crucial as it forms the foundation of various trading strategies.