What Is the Market-Maker Spread?
The market-maker spread is the difference between the price at which a market-maker (MM) is willing to buy a security and the price at which it is willing to sell the security. The market-maker spread is effectively the bid-ask spread that market makers are willing to commit to. It is the difference between the bid and the ask price posted by the market maker for security.
This spread represents the potential profit that the market maker can make from this activity, and it's meant to compensate it for the risk of market-making. The risk inherent in a given market can affect the width of the market-maker spread: High volatility or a lack of liquidity in a security will tend to increase the size of the market-maker spread.
Key Takeaways
- The market-maker spread is the difference in bid and ask price set by the market makers in a particular security.
- Market makers earn a living by having investors or traders buy securities where MMs offer them for sale and having them sell securities where MMs are willing to buy.
- The wider the spread, the more potential earnings an MM can make, but competition among MMs and other market actors can keep spreads tight.
- High volatility or increased risk can lead to MMs widening their spreads to compensate.
Understanding the Market-Maker Spread
Market makers' job is to add liquidity to markets by being ready to buy and sell designated securities at any time during the trading day. While the spread between the bid and ask is only a few cents, market makers can profitby executing thousands of trades in a day and expertly trading their “book.” However, these profits can be wiped out by volatile markets if the market maker is caught on the wrong side of the trade.
Market makers, who may be either independent or an employee of financial firms, offer to sell securities at a given price (the ask price) and will also bid to purchase securities at a given price (the bid price). MMs earn a living by having market participants buy at their offer and sell to their bid over and over again, day in and day out.
The market-maker spread can be considered a measure of the liquidity (i.e. the supply and demand) of a particular asset. As market makers are more willing to bid or offer, there are larger sizes on the spread, and larger volumes can transact without moving the market too much. Market-maker spreads tend to be tighter in more actively traded names, and in those that have more market makers available to make markets.
Special Considerations
Rather than tracking the price of every single trade in Alpha, MM’s traders will look at the average price of the stock over thousands of trades. If MM is long Alpha shares in its inventory, its traders will strive to ensure that Alpha's average price in its inventory is below the current market priceso that its market-making in Alpha is profitable. If MM is short Alpha, the average price should be above the current market price, so that the net short position can be closed out at a profit by buying back Alpha shares at a cheaper price.
Market-maker spreads widen during volatile market periods because of the increased risk of loss. They also widen for stocks that have a low trading volume, poor price visibility, or low liquidity.
Example of Market-Maker Spread
For example, imagine that a market maker MM in a stock – let’s call it Alpha – shows a bid and ask price with a quote of $10.00 - 10.05. This means that this MM is willing to both buy Alpha shares for $10 and sell it at $10.05. The spread of 5 cents is the potential profit per share traded to the market maker. If MM can trade 10,000 shares at the posted bid and ask, its profit from the spread would thus be $500.
