What Is the Market-Maker Spread?

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. 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). 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 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. 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 price so that its market-making in Alpha is profitable.

The market-maker spread is the difference in bid and ask price set by the market makers in a particular security.

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.

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 profit by 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 price so 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.

Related terms:

Ask

The ask is the price a seller is willing to accept for a security in the lexicon of finance. read more

Average Price

Average price is the mean price of an asset or security observed over some period of time. read more

Bid and Ask

The term "bid and ask" refers to a two-way price quotation that indicates the best price at which a security can be sold and bought at a given point in time.  read more

Bid-Ask Spread

A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. read more

Bid

A bid is an offer made by an investor, trader, or dealer to buy a security that stipulates the price and the quantity the buyer is willing to purchase. read more

Liquidity

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. read more

Make a Market

Make a market is an action whereby a dealer stands by ready, willing, and able to buy or sell a particular security at the quoted bid and ask price.  read more

Market Price

The market price is the cost of an asset or service. In a market economy, the market price of an asset or service fluctuates based on supply and demand and future expectations of the asset or service. read more

Market Maker

Market makers compete for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. read more

Net Short

Net short refers to the overall positioning that an investor has in their portfolio—more short positions than long in terms of overall value. read more