Market Makers

Market Makers are the essential middlemen of the financial world. Think of them as the master wholesalers of the stock market. A market maker is typically a large financial institution that commits to continuously buying and selling a particular security—like a stock or an ETF—at publicly quoted prices during market hours. They do this by providing a two-sided quote: a bid price, which is the price they are willing to pay to buy the security from you, and an ask price, which is the price they are willing to accept to sell it to you. By always standing ready to trade, they ensure that there's a constant supply and demand, which is a fancy way of saying they provide liquidity. This service keeps the market running smoothly, so you can buy or sell shares instantly without having to wait for another individual investor to show up on the other side of your trade.

Market makers aren’t charities; they are in it to turn a profit. Their primary income comes from a simple, yet brilliant, mechanism.

The main profit engine for a market maker is the bid-ask spread. This is the small difference between the ask price (their selling price) and the bid price (their buying price). Let's say a market maker for “Value Investing Corp.” quotes the stock as follows:

• Bid Price: $50.00 (The price they’ll buy it from you)
• Ask Price: $50.05 (The price they’ll sell it to you)

The bid-ask spread here is $0.05. If you sell 100 shares to the market maker, they pay you $5,000. If another investor comes along moments later and buys 100 shares from the market maker, that investor pays $5,005. The market maker pockets the $5 difference simply for being the go-between. While five bucks doesn't sound like much, multiply that by millions of trades across thousands of stocks every day, and you can see how it becomes a very lucrative business. The size of the spread is often an indicator of the stock's liquidity.

• Tight Spreads: Highly traded stocks like Apple or Microsoft have immense trading volume, so the risk for the market maker is low. The spread might be as narrow as a single cent.
• Wide Spreads: A small, obscure, or less-traded stock has lower volume. This means the market maker takes on more risk because they might have to hold the shares for longer before finding a buyer. To compensate for this risk, they charge a wider spread.

While they profit from every trade, market makers play a crucial role in maintaining a healthy and functional market.

Imagine a world without market makers. To sell your shares, you’d have to find a specific buyer who wanted your exact number of shares at your exact price, at that exact moment. It would be chaotic and inefficient. Market makers solve this problem by always being there to take the other side of your trade. They are the reason you can click “buy” or “sell” and have your order filled almost instantly. They transform the market from a clunky barter system into a fluid, high-speed exchange.

Market makers also act as giant shock absorbers. By constantly quoting prices and absorbing large buy and sell orders, they help to reduce extreme price volatility. If a massive fund decides to sell a huge block of shares, market makers will step in to buy them, preventing the stock’s price from plummeting in a matter of seconds. They provide a buffer that helps create more orderly and stable price movements.

For a value investor, who is focused on a company’s long-term fundamental worth rather than short-term market noise, what does any of this matter? It matters in a practical sense.

The bid-ask spread is a real, though often hidden, transaction cost. Every time you buy, you pay the slightly higher ask price, and every time you sell, you receive the slightly lower bid price. Over a lifetime of investing, this “toll” paid to market makers can subtly eat into your overall returns. It's a small but important factor to remember—you always start a new position slightly “in the red” because of the spread.

Value investors often hunt for bargains in less popular, under-the-radar companies. These stocks are frequently less liquid, which, as we've learned, means they have wider bid-ask spreads. Being aware of this is key to executing your strategy effectively. When buying an illiquid stock, using a limit order is often a wise move. A limit order lets you specify the maximum price you are willing to pay. This prevents a scenario where you, in your eagerness to buy, end up paying a much higher price than you intended just to cross the wide spread and get your order filled. Understanding the role of the market maker doesn't change the principles of value investing, but it does make you a savvier, more cost-conscious investor when putting your capital to work.