How is a market-maker able to make delivery on their bid and ask prices? Do they always have stock ready? Do they go and buy when they want to sell? Do they have to "fund their positions"? What does that even mean? Do they use their own start-up capital?
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Is this specific to equities?– Rodrigo de AzevedoFeb 4, 2023 at 13:00
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2 Answers
How is the market maker able to make deliver on their bid and ask prices?
They are NOT. They are MOST OF THE TIME ready - but there are times they basically kill their book and do not offer one or both sides. They are legally (by exchanges) obligated to keep a book a certain percentage of time, and often do more, but the statement of always is WRONG. And there is a lot of markets and possibly a lot of ways a market maker can possibly offset market risk for a specific order.
Do they always have stock ready?
Likely not, but there are a lot of exchanges and if the price deviates enough from what they can cover on other exchanges or through other means (i.e. options) they will put in a price.
Do they have to "fund their positions"?
OBVIOUSLY they must have the funds to fund what they own or owe at the end of the day. You think they are magically special, allowed to be broke?
What does that even mean?
No idea. Quite a lot of your questions make me think you do not know what you actually are asking. Obviously funding the positions means having the funds for the positions. You buy stocks for 10k USD you must pay up at some point.
Do they use their own start-up capital?
No. They use their own CAPITAL. Note that I do not say startup capital and I seriously do not understand why you even would consider the funding of any trading operation to be "startup capital". People with 10+ years of experience do not have "startup" capital, they have capital. And people do not just go and grab some seed money and play market makers - unless they have a TON of money in their trading account.
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After a bit more research, I read Principles of Financial Engineering (3rd ed) by Neftci. On page 278 he says "market makers never have money of their own". The trade needs to be funded, and this maybe through debt. While I appreciate your first answer, your others are lacking. Jul 11, 2020 at 19:55
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2Really? After no more research except me being a market maker on about a dozen exchanges I can tell you that my answers are all right.– TomTomJul 11, 2020 at 20:43
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How could you fail to mention that some positions are funded by borrowing? Jul 11, 2020 at 22:20
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2Because this is normal operations for any business? You ahve capital, you have a credit line against your capital. I am not sure why you assume market makers are not a business.– TomTomJul 11, 2020 at 22:22
A market maker can be an individual (local trader), brokerage firm, or large institution. They are well capitalized and they carry inventory. They profit from the difference in the bid-ask spread, compensation for the risk of holding inventory.
For their inventory, market makers bear the risk of adverse price movement. OTOH, they benefit when the security moves favorably. Therefore, risk management plays a large part in the their success. This is much easier in securities that offer options because risk can be laid off with arbitrage strategies and delta neutral hedging. For non option stocks, hedging is also done but with other securities.
answered Jul 11, 2020 at 17:29
