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I am familiar with how currency exchange booths at airports make some of their money: from the bid-ask spread. For example, they will say: "you can sell us 1 USD for 1.32 CAD, and you can buy 1 USD from us for 1.33 CAD". From the perspective of the customer, the ask price fixed by the currency exchange booth (1.32 CAD) is lower than the bid price (1.33 CAD).

However, on the stock market, the bid price is almost invariably lower than the ask price. How does the market maker make any money out of this? Suppose the highest bid is $100, and the lowest ask is $101. The market maker will make a loss by buying at $101, and selling at $100. In fact, the bid price must be higher than the ask price for the market maker to profit from the bid-ask spread in this manner. But from my observations, the bids in the market are always lower than the asks.

I suspect that I have a fundamental misunderstanding of market-making. So my question is: how do market makers actually profit from the bid-ask spread?

  • The market maker will make a profit by buying at $100, and selling at $101. The quotes that you see are after the fact that market maker is participating. – base64 May 23 at 2:56
  • @base64 How can I observe the live actions of the market maker(s)? – Flux 2 days ago
  • Level 2 Quote "Deep Book" and "List of last trades" – base64 2 days ago
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This income comes from fact most people don't want to wait and just buy/sell on current price. While market maker is ready to wait and buys/sells on a better price. Here is a simple example:

1) MM puts

  • BUY MSFT@$100 order - he is ready to buy MSFT for $100
  • SELL MSFT@$101 order - he is ready to sell MSFT for $101

To simplify, imagine that he has no MSFT stocks.

2) So now customer A comes to exchange and wants to sell MSFT stock now, without having to wait, so he just sells it to MM for $100.

Now MM has +1 MSFT stock and -$100

3) After 50 minutes, customer B comes to exchange and wants to buy MSFT stock and he also doesn't want to wait, so he buys it from MM for $101

Now MM has 0 MSFT stocks and $1 profit.

This is strongly simplified version of MM, but main idea is like this.

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  • Maybe not after 50 minutes, but after 10 seconds. Plus there is the Triangular Arbitrage for forex and multi-listed companies. – base64 May 22 at 11:11
  • But when I look at the bid and ask prices in the market, the bid price is always lower than the ask price? If the scenario in your answer occurs, wouldn't the bid price have to be higher than the ask price? – Flux May 22 at 11:56
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    @Flux But the bid price 5 minutes from now may be higher than the ask price now. – glibdud May 22 at 12:00
  • This isn't Forex nor does Triangular Arbitrage have anything to do with the basic process of B/A counter parties and NBBO. – Bob Baerker May 22 at 15:10
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It’s the other way around: if it’s $100 bid and $101 ask the MM is asking for $101, i.e., offering at that ask price.

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Your fundamental understanding is correct. The problem is that you're just not connecting a few of the dots.

Consider your airport currency exchange. Think of it as 1.32 CAD is the bid and 1.33 CAD is the ask. The exchange booth is the market maker. It is buying at the lower priced bid and selling at the higher priced ask. It has a lock on the market and if you excuse the expression, it is printing money. The more people who convert currency, the more money it makes. There is no risk whatsoever in this narrow construct.

For your stock market example, just substitute the words 'market maker' for 'exchange booths' and substitute $100 x $101 for 1.32/1.33 CAD. The market maker is buying at $100 and selling at $101. For market orders, any trader who buys at the ask price of $101 is selling to the MM at the higher price and any trader who sells at the lower bid price of $100 is buying from the market maker. Similar to the exchange booth, the market maker is 'printing money'.

However, there is a big difference between the currency and stock examples. Within seconds, the stock can dramatically fluctuate in price and the MM is required to continuously quote prices at which it will buy and sell the security. Earning the spread compensates the MM for this risk. Note that any trader can become the market on one or both sides by offering a higher bid and/or lower ask price

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  • In your example, the bid is $100 and the ask is $101. You say that the market maker is buying at $100, but how is that possible? When market participants place bids at $100, they are looking to buy at $100 (i.e. they are not selling, but buying). How does the market maker buy at $100 if no one is selling at $100? – Flux May 22 at 14:38
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    You are conflating limit and market orders. If the quote is $100 by $101 and you agree to buy at the market price of $101, the counter party receives $101 for the sale. That is the market maker. He is SELLING at the higher price. If you do not want to pay the market price of $101 and you are only willing to pay $100 then you place a limit order at that price. You and the MM are now at the $100 bid but your order has precedence. Read this – Bob Baerker May 22 at 15:07
  • @Flux, when an individual submits a marketable limit order to sell at $100, or a market order to sell at $100, his/her order does not appear as bid/ask. It will be matched with existing bid order of the market maker, and both would disappear. – base64 May 23 at 3:00
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For example, they will say: "you can sell us 1 USD for 1.32 CAD, and you can buy 1 USD from us for 1.33 CAD". From the perspective of the customer, the ask price fixed by the currency exchange booth (1.32 CAD) is lower than the bid price (1.33 CAD).

You have it backwards. 1.32 CAD is the bid price (the advertised price at which the booth will buy 1 USD) and 1.33 is the ask price (the advertised price at which the booth will sell).

Suppose the highest bid is $100, and the lowest ask is $101. The market maker will make a loss by buying at $101, and selling at $100.

Same here. If the highest bid is $100, that means that the market maker (or someone with a competing bid) is buying at $100. If the lowest ask is $101, then the market maker (or competitor) is selling at $101. With each round trip, the market maker buys at $100 and sells at $101, making a profit of $1.

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