Learn about market makers and their function — Stock-Market notes

WHAT is a market maker?

The distance between these two quotes is the heart of the whole business:

Formula The Bid–Ask Spread

$\text{Spread} = P_{\text{ask}} - P_{\text{bid}}$ WHY it exists: the spread is the market maker's compensation for standing ready to trade at any moment and for taking on the risk of holding unwanted inventory. Derivation from first principles: Suppose the market maker believes the security's "true" fair value is $P_{\text{mid}}$ . To make a profit while being neutral about direction, they place their buy quote below fair value and sell quote above it: $P_{\text{bid}} = P_{\text{mid}} - \tfrac{s}{2}, \qquad P_{\text{ask}} = P_{\text{mid}} + \tfrac{s}{2}$ Subtract: $P_{\text{ask}} - P_{\text{bid}} = s$ . So the chosen half-spread $\tfrac{s}{2}$ on each side builds up to the total spread $s$ . If they buy one share and immediately sell one share, their gross profit is exactly $\pi = P_{\text{ask}} - P_{\text{bid}} = s.$

HOW a market maker actually earns (the round-trip)

Figure — Learn about market makers and their function

WHY markets need them (their function)

Steel-manned mistakes

Active Recall

Recall Try before revealing

What two prices does a market maker quote, and from whose viewpoint?
Derive the round-trip profit of a market maker.
Why must the spread be strictly positive?
What is inventory risk and how does it affect quote width?
Do you buy at the bid or the ask?

Recall Feynman: explain to a 12-year-old

A market maker is like a money-changer at the airport who always has a table open. They say: "I'll BUY your dollars for ₹82 and SELL you dollars for ₹84." They keep the ₹2 gap every time someone trades. They don't gamble on whether the dollar goes up or down — they just want lots of people to swap money through their table. The gap is their pay for always being open so you never have to wait. If suddenly everyone only sells dollars to them and nobody buys, they get stuck with a big pile of dollars that might lose value — that's their scary part, so on risky days they make the gap bigger to protect themselves.

Connections

Liquidity and Depth in Markets
Bid-Ask Spread and Order Books
Types of Market Participants
Price Discovery Mechanism
High-Frequency Trading
Order Types — Market vs Limit Orders

What is a market maker?

A firm that continuously quotes both a bid (buy) and ask (sell) price for a security, providing liquidity so others can trade immediately.

From whose perspective are bid and ask quoted?

The market maker's — they BUY at the bid and SELL at the ask.

Do you (a retail trader) buy at the bid or the ask?

At the ask (the higher price); you sell at the bid (the lower price).

Define the bid-ask spread.

Spread = P_ask − P_bid; the market maker's compensation for providing liquidity and bearing inventory risk.

Derive a market maker's round-trip profit.

Buy 1 share at P_bid, sell 1 at P_ask → profit = P_ask − P_bid = the spread.

Why must the spread be positive?

A zero spread earns nothing while still bearing inventory risk, so no rational firm would provide liquidity for free.

What is inventory risk?

The risk that a market maker is forced to hold a security whose price moves against them before they can offload it.

Why do spreads widen in volatile/illiquid stocks?

Higher risk of adverse inventory moves and difficulty unloading → market makers demand a bigger spread as insurance.

What is the relative spread and why normalize?

(P_ask − P_bid)/P_mid; dividing by mid-price makes spreads comparable across stocks of different price levels.

Are market makers directionally biased?

No — they aim to be neutral, earning the spread on balanced flow regardless of price direction.

List four functions of a market maker.

Provide liquidity, ensure continuous prices, reduce volatility from order imbalances, aid price discovery.

What is the mid price formula?

P_mid = (P_bid + P_ask)/2, an estimate of fair value.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Socho ek airport pe money-changer baitha hai jo hamesha bolta hai: "Main tumse dollar ₹82 me KHARIDUNGA (bid) aur tumhe ₹84 me BECHUNGA (ask)." Bas yehi kaam market maker karta hai stocks me — woh do prices hamesha quote karta rehta hai taaki jab bhi tum turant buy ya sell karna chaho, tumhe koi counterparty dhoondhna na pade. Isko hi liquidity dena kehte hain. Uski kamaai hoti hai us chhote gap se, jise spread kehte hain: $\text{Spread} = P_{ask} - P_{bid}$ .

Important baat: market maker ko price upar jaaye ya neeche, usse farak nahi padta — woh direction-neutral hota hai. Agar ek share ₹100.00 pe khareeda aur ₹100.10 pe becha, to ₹0.10 profit — bas spread. Din bhar lakhon baar aisa hone se paisa banta hai, bashart buying aur selling ka flow balanced rahe. Yaad rakho: tum hamesha ask pe kharidte ho (mehnga) aur bid pe bechte ho (sasta) — quotes market maker ke point of view se hoti hain, tumhare nahi.

Risk kya hai? Agar sab log sirf bech rahe hain aur koi khareed nahi raha, to market maker ke paas bahut saara stock jama ho jaata hai — isse inventory risk kehte hain. Agar tabhi price gir gayi to loss. Isiliye jo stock volatile ya kam-volume wala hota hai, uska spread bada hota hai — yeh insurance ki tarah hai. Blue-chip stocks me competition zyada hota hai to spread patla (₹100.00/100.05), aur small-cap me mota (₹99/101). Yeh cheez samajhna zaroori hai kyunki jab tum trade karte ho, spread tumhari hidden cost hoti hai.

Test yourself — Market Participants

Connections