Do you ever wonder where trades come from?
Yes, you may put the order through, and pay for the options contract or stock from your account…
But how do these trades actually get filled?
Your broker isn’t magically matching perfect pairs of buyers and sellers within seconds for each transaction …
It’s actually done through a third party: a market maker.
Make Markets, Not War
These market makers “make markets” – that is, they keep markets liquid by buying or selling securities at certain prices at
You want 1000 shares of Apple (Ticker: AAPL)? No problem, a market maker will sell them to you.
You want to sell 1000 shares of AAPL? No problem, a market maker will buy them.
I actually spent much of my early career as a market maker, so I have unique insight into how market makers work.
Here’s my insight into how they operate, how they’re able to take on so much risk, and how they make their money.
Magic Markets? Not Quite.
First, let’s go through what a market maker is (and is not).
A market maker is not a magical void into which any trade, at any time, can be put in and filled.
What a market maker is is someone who will offer both the bid and the ask side of the market on a particular security for a certain amount of shares (or contracts) – they’re “making the market.”
A market maker takes the opposite side of a buy or sell order – so if you’re looking to sell your shares of a stock, or options contract, they’ll buy it at the bid price. Or if you’re looking to buy an options contract or shares of a stock, they’ll sell them to you at the ask price.
This ensures market liquidity, so traders don’t have to wait around for someone else to come take the opposite side of their trade. The market maker fills that role, allowing trades to be filled much more quickly than if each trade had to be individually matched to both a buyer and a seller.
Market Makers Make Money
Of course, the market maker makes money on each transaction they process.
During your trading, you’ve undoubtedly noticed that the prices you can buy and sell at (the ‘ask’ price and the ‘bid’ price) are different.
This is where market makers profit.
See, market makers take on a risk every time they take the opposite side of a trade. If you sell them 100 shares of Ford (Ticker: F) at $13.50, and seconds later, before the market maker can sell the shares, F plunges to $12, the market maker is now stuck holding those shares, unable to sell them for the price they purchased them for.
So, to make up for situations like this, and ensure they come out ahead overall, they earn money on every transaction through the bid-ask spread.
Let’s go back to that hypothetical Ford trade. Say F shares are currently worth $13.50.
The market maker might offer to buy F for $13.45 – the bid price, which is the price you would be selling at.
On the other side, if someone is looking to buy F, the market maker might offer an ask price of $13.55.
When the market maker successfully buys and sells F at this bid-ask spread, they’ve locked in $0.10 of profit simply for facilitating the trade, and taking on the risk that comes with being the middleman.
It may not sound like much, but these market makers are doing this thousands and thousands of times each day.
In reality, you would likely see a much tighter bid-ask spread on a high-volume stock like F – think more along the lines of $0.02:
The actual bid-ask spread on F
However, for a low-volume (and therefore higher risk for the market maker, as they will have a more difficult time finding someone to take the opposite side of the trade) you’ll likely see a larger bid-ask spread.
Fulgent Genetics (Ticker: FLGT) has a fairly wide bid-ask spread.
A market maker can also move markets – that is, change the bid-ask spread based on the supply, demand, and current price of the equity.
Now – making markets for stocks and making markets for options are quite different beasts.
So Many Options
When you are making a market for a stock, you are tracking the fair value of the underlying.
But when you are making a market for options, you have hundreds (or even thousands!) of quotes to keep track of; think of all of the different terms and strikes available to trade on a single equity!
So how are they able to do this?
Rather than basing the bid-ask spread on the price of the underlying, the market maker sets their prices based on a pricing model that takes into account the strike price, time to expiration, price of the underlying, cost of carry, and implied volatility.
So the options market maker does not simply arbitrarily move the whole price of the option around. Rather, they move the ‘volatility’ piece of the equation around to determine their pricing and make markets.
For example, the options market maker may set the ‘fair value’ IV of an option at 50 IV points. Therefore, his or her bid prices will be based on a lower volatility, such as 49.8 IV points, and his or her ask prices will be based on a higher volatility — in this example, maybe 50.2 IV points.
So if the ‘fair’ price of an option, according to the pricing model, is $2.00, then the market maker would adjust the implied volatility piece of the pricing model to reflect their ‘bid’ and ‘ask’ volatilities – so, for example, the bid price of the option may be $1.98, while the ask price may be $2.02.
Market makers can also move these volatilities around, based on the demand for certain options (since it is inferred that higher demand for options signals traders are expecting movement, therefore higher IV).
We could get really into the weeds with this, but hopefully this gives you some idea of how market makers make their money. The more you know about pricing, the more informed you can be when it comes to choosing your own trades.
Your Only Option,