Market Overview

So Just What Are Market Makers?

So Just What Are Market Makers?

When you first learned that market makers existed, you probably wondered if they were good or bad and then you probably wondered how they worked.

Market makers are liquidity providers. They help ensure that trades can easily be entered and exited. They want their Delta to be neutral, to do this they need to buy at the bid and sell at the offer. Delta is defined as “The ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative.” (Investopedia)

They do not want to be directional, as that would mean they would be Delta Long or Delta Short and they want to maintain their Delta Neutral. The main part of the bid/ask spread originates when there is a lack of Delta neutrality during a lack of liquidity. If the market maker cannot pass off the risk immediately, there is a wider bid/ask spread. If they lose their Delta neutrality temporarily, they will need to build in additional profit in the bid/ask spreads.

It is important to know that the market maker is not bad. Market makers are not out to get you nor are they hunting for your stops or trying to move the market to make you lose. It is not you against them for they do not hold stock or anything else. They want to post bids and offers to ensure liquidity is available. If you want to buy it, they will sell it. If you want to sell it, they will buy it.
Market makers make money by buying from people at the bid and selling to people at the ask.

However, competitions between traders and market makers on the same exchange will help traders more than if traders and market makers were spread between several exchanges. More market makers and traders mean more benefits for both. If there are more market makers, there will be more liquidity for traders, which will attract more traders to the exchange enabling more positions being bought and sold.

Market makers want to unload their risk so badly that they stumble over each other in order to do so. This brings the bid/ask spread closer and closer. In order to clarify, the bid/ask spread is the difference in the price of the bid and the price of the offer or ask. If the bid is 53 and the ask is 57, the difference is 4. If you were to buy a contract at 57, you would have to sell at 53 in order to get out of the trade immediately, which would result in a loss of $4. Likewise, if you sold at 53, and wanted to get out of the trade immediately before the market moved, you would have to buy the contract back at the cost of 57 to get out of the trade. This is again a loss of $4. By decreasing the difference in the bid/ask spread, you limit your loss which can add up to substantial savings.

Let’s look at a scenario of how this all works:

Suppose the bid is 53 and ask is 57. A trader sold at 53 and Market Maker A got filled at the bid price, which makes him long the contract. He will lose his Delta neutral position if the market falls.

Both Market Maker A and B have a quote of 57 on the offer or ask for them to sell to a buyer. Remember market makers like to stay Delta neutral and since Market Maker A bought the contract, he is Delta long, which he does not want. Market Maker A steps in front of Market Maker B by placing a bid to sell to a buyer at 56. He “trips over” Market Maker B helping to ensure that he gets the fill should a trader take the other side.

However, if Market Maker B also needs to unload contracts, he may step in front of Market Maker A by placing a bid to sell at 56, thus tightening the bid/offer spread even more.

Now, suppose there are other Market Makers and traders. This will further tighten up the bid/ask spread. The more traders and market makers on the exchange, the more orders are being filled. They all seem to want to hedge off the trade which makes the bid/ask spread even smaller.

By tightening up the bid/ask spread, this limits the amount of loss shown on the Profit and Loss when you enter your trade. Instead of automatically being down $5-8, you may only be down a dollar or two. Sometimes spreads are so tight; there is no difference at all.

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The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.


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