Over the last several months i have been taking a more hands on approach to my TD Ameritrade account.
Every stock has market markers that, from what i can tell, match buyers with sellers, and in return get to profit from the difference between the bid and ask.
My question is, do these market makers have risk?
If so, what could it be?
Presumably just the usual risks involved with handling massive sums of money and the need to provide a reliable real time service, with outages costing money.
Market makers always match buyers and sellers if you want to count them as the buyer or seller. They often buy stock when no other buyer is around. They can then lose money the same way anyone else does if the price goes down.
Market makers by definition make markets. In normal terms, this means that market makers are willing to buy (at a price) when everyone else is selling, and vice versa. Market makers can easily be caught out, but they have much wider spreads to compensate for it.
Market makers are not risk free arbitragers that only buy when they have buyer lined up to sell to.
Make sense?
The risk is when the stock drops. They are required to buy a stock at the current price.
Say GE is at 23. It drops to 20 and people are still selling. The market maker has to buy the stock if there are no buyers at the price. Then the stock goes down to 18. Now they have stock they paid 20 for, but which they can only sell at 18. And if there are no buyers at 18, you have to buy that, too. If the stock continues to dip, you stand to lose a lot.
It evens out (if you’re a market maker, you make a market in many stocks to prevent heavy losses). If another stock goes up after you buy it, you can sell it at a profit.
They are by definition exposed. They have to buy and sell at their quoted bid and ask numbers. When prices are changing rapidly, they can widen their bid-ask spread to reduce their risk somewhat. You can especially see this in more thinly traded instruments like options. Of course there is the temptation to widen the spread even without volatility to improve profitability - again see certain options.
Remember the market maker gets to see all willing buyers and sellers at any time, and so should have a decent read on the price move in the next seconds. Since their objective is not typically to build a position either way in the security, I imagine they move their bid-ask to make the volumes of buy and sell be even in a matter similar to sports betting bookies.
Remember they will change their bid-ask quotes very, very rapidly - it’s not like they’re still buying at 50 when everyone is selling at 49.99. They drop to 49.98 - 49.92- 48,50 etc very quickly till prospective buyers and sellers balance.
Market makers necessarily take a position in the subject company’s stock, in order to have shares to meet buy orders. They generally hedge this risk by taking an equivalent short position in the stock
Of course, market makers are also exposed to risk from movements in the stock as they trade, as others have mentioned. Their buy-sell spreads become wider as volatility increases.
I’ll ask some questions when I get to work tomorrow, but don’t equity market makers also strive to stay delta neutral?
I hope some expert will help us understand the differences between NYSE Specialists 50 years ago and those of today. First correct my own understanding of the specialists 50 years ago.
The specialist broker provided market-making service on a handful of stocks, and placed himself in a fixed location on the NYSE floor, announcing “bid 98 ask 99” or whatever to any passers-by. If his spreads were too wide, or if he made mistakes or frauds, management would evict him from his coveted profitable position. I suppose the specialist may have had informants who would occasionally phone in “Turbine explosion in Cincinnati. Run and tell Luke the specialist!” Of course there was nothing stopping another broker from preëmpting the specialist, calling “bid 98⅛ ask 98⅞” in response to “bid 98 ask 99.”
But what about now? Has the human specialist been replaced with a computer program? Aren’t there HFT algorithms constantly undercutting a market-maker: where’s the profit-making opportunity now? And instead of a phone call warning about the turbine explosion, what happens now? Is there automatic software which scans Reuters and other news feeds, and widens the spread whenever a company name matches a string in the newsfeeds?
Generally speaking, yes. But this can be difficult to do if the portfolio is large, and comes with its own risks and expense.
This is a bit misleading. A market maker is never required to buy or sell stock at the “current” price, he always sets the prices at which he is willing to trade.
A market maker is contractually obligated to maintain liquidity - that is, he must always be willing to both buy and sell stock at some price. The obligation is specified as the bid-ask spread he must always maintain, i.e. the difference between buy and sell prices.
For example, suppose the obligation for the market maker in widget-maker WXX is to maintain a maximum 1% bid-ask spread in 1,000 shares. His current bid-ask might be 120/121. This means that he is currently willing to buy at least 1,000 shares of WXX at 120 or sell 1,000 shares at 121, but only so long as this quote is current. If news of a widget glut hits the wire, the market-maker would instantly react to that news, he might immediately change his quote to 115/116 - hopefully before anyone has time to sell any shares to him at $120. He has no obligation to buy any stock between 120 and 115 unless someone executes a trade with him before he changes his quote. But if his current quote is that he’s now willing to pay only $115 to buy stock, he does have an obligation that he must also be willing to sell stock at a price no more than 1% higher than the new bid, i.e. at around $116, i.e. he must maintain the bid-ask spread of no more than 1%.
The art of market making is to discount news, and to react to the general ebb and flow of supply and demand, in such a way that buyers and sellers roughly balance out at the current quoted bid-ask. In the above example, let’s say the $5 drop in price to discount the news of the widget glut is correctly judged: perhaps some people are still panicked at the news and will sell WXX at $115; while others think WXX is now cheap and come in to buy at $116. If the market maker gets it right like this, he may do business on both the bid and ask sides of his quote, making a profit on his bid-ask spread. But if he gets it wrong - let’s say the news is more negative than he perceives - then he may still see only sellers at his new bid of $115. In this case, after buying some stock at $115 he might react again to drop his price further, let’s say now 112/113, and he would have lost money on any stock he bought at $115 before dropping his price.
But market makers are never under any obligation to buy or sell stock and any particular price, just to maintain the bid-ask spread. So they are not really a “buyer of last resort”, more a liquidity-provider of last resort. This means that investors can always have confidence that the market will not vanish, there will always be some price available to trade with reasonable transaction costs (bid-ask spread, 1%). Market makers are an important part of the price discovery mechanism.
No, a net short position may involve certain technical steps to maintain, but economically it’s simply the opposite of a long position. Buys and sells net out. A market maker has either a net long or short position at any point in time. If he’s long and he doesn’t like the position he will simply try to sell it; if he’s short and he doesn’t like it he will buy to “cover” his short.
Delta is used by derivates traders to express their market exposure in terms of equivalent number of shares in the cash market. It’s not really applicable to a discussion of market makers in the cash market.
What I wrote above describes the extent to which market-markets are contractually obliged to risk their own capital, the OP’s primary question.
In the normal operation of a market, however, there is more than one market maker, and investors and speculators are also constantly entering orders, often with limit prices. So only in times of extreme market disruption would the market maker’s bid-ask be (briefly) the only price available. More usually, if a market maker’s bid-ask for WXX is 120/121, the overall market for WXX might include many other limit orders, something like:
121.0 - 1,000 (market maker’s current offer)
120.9 - 500
120.8 - 100
120.6 - 1,000
120.4 - 5,000 current best offer - a large limit sell order
120.3 - 1,000 current best limit bid
120.2 - 500
120.0 - 1,000 (market maker’s current bid)
The market maker (if he’s a NYSE specialist) would also be involved in “organizing” this auction. The price at which he’s currently prepared to risk his own capital to buy is 120.0, or to sell 121.0. But other investors and speculators are also participating with limit buy or sell orders on display. If somebody comes in with an order to buy 1,000 shares “at market”, that gets executed at the best offer available (120.4), and the market maker does not participate as a principal (does not commit his own capital to either side of the trade). In virtually all markets, this process is now all handled electronically, of course.
The critical role of the market maker is that when things go crazy, there may be no limit orders showing at all, and the bid-ask “guess” for the new market level that he is obligated to provide is a starting point for price discovery, in order for incoming sell and buy orders to “clear”, and for the market to re-establish equilibrium at some new level.
Well, yes, it isn’t really a short position. A market maker typically enters into a short sale against the box that is equivalent to its holdings of the issuer’s shares, so that its net position is neither long nor short. Because the market maker will then engage in trades, it will in fact have a net long or net short position at any given point in time. I didn’t think that level of detail was worth going into.
Here’s a decent brief article on NYSE & NASDAQ market makers:
My point was that in terms of the OP’s question - to what extent does a market maker risk his own capital - his capital is at risk to the extent that he holds a (net) long or short position. He would not think in the way you imply: “I’m long, so I’ll hedge that by going short”; he always automatically thinks in terms of his net long or short position. If he’s caught long with the price dropping, and feels it’s wrong, he would simply sell his long position to some other bid that’s showing in the market, or move his own bid-ask down far enough to attract new buyers. If he’s caught short, he will take some offer showing in the market to cover, or move his bid-ask up high enough to attract sellers.
Riemann’s posts are solid.
For whatever reason, people have an impression that market makers operate in some parallel realm where they just print money all day. Market makers face the same economic consequences of their buying and selling decisions as any other market participant. If they buy and the price goes down, they lose money. Yes, there are certain structural advantages to be gained by registering with the NASDAQ or NYSE as a market maker. However, these are generally in the form of slightly discounted commission or fees (eg: paying trading fees of $0.0001/share vs. $0.0002 per share). Larger advantages existed decades ago when the NYSE had a monopoly on trading in a stock. However, the current electronic market is extremely competitive with (mostly) high-frequency traders battling each other to make the most competitive market.
Think of any antique dealer, baseball card shop (do these still exist?), or business that buys and sells inventory. They are essentially market makers. They use their expertise to price merchandise based on market price trends, market activity, inventory holding costs, etc. Securities market makers do the same, but their product is stock, bonds, or commodities.
Yup, I described the basic principles behind what market making involves, but the simplified sceanarios I described would rarely play out that way today, except maybe in illiquid names. The reality today is that dozens of players are constantly involved, both the formally designated market makers and many other proprietary players, all with sophisticated computer algorithms, all both making and taking prices electronically, factoring in everything that’s going on not just in one stock, but in many other correlated stocks and in the market as a whole. Being a formally designated market maker isn’t much of an advantage in itself, you’re trading on exactly the same playing field as any other participant.