Market Maker
A firm that continuously quotes both buy and sell prices for a security, providing liquidity to the market and earning the bid-ask spread in exchange for taking on inventory risk.
Market Maker · the mechanism
1 min read
Explain how a market maker earns the spread, what actually threatens that income, and why they skew a quote.
Where it comes up. The interview exercise where you are asked to make a market in something unknowable, and are then traded against twice on the same side.
Quote both sides, capture the difference
A market maker posts a bid and an offer at the same time and stands ready to trade either. If one buyer and one seller arrive, they buy at the bid, sell at the offer, end flat, and keep the spread. That is the whole business in one sentence.
Manage inventory
Flow rarely arrives balanced. Sell more than you buy and you are short, exposed to a rally you did not choose. The response is to skew: shade both quotes in the direction that attracts the flow you need. A short maker raises their bid to buy more readily and raises their offer to sell less readily.
Price adverse selection
The dangerous counterparty is the one who knows something. Everyone who trades against you did so because your price was attractive to them, which means the maker is systematically on the wrong side of informed flow. The spread has to be wide enough that uninformed volume pays for the informed trades. This is why spreads widen before earnings and blow out in a crisis, when almost every trade is informed.
Worked through
A maker quoting 249.80 / 250.20 in 5,000 lots, over three trades.
- Sells 5,000 at 250.20
- Short 5,000. Cash +£1,251,000
- Sells another 5,000 at 250.20
- Short 10,000. Cash +£1,251,000
- Skews to 249.95 / 250.35 and buys 10,000 at 249.95
- Flat. Cash −£2,499,500
Profit £2,500 on £2.5m of turnover, which is 10 basis points, less than the 16bp quoted spread, because the skew that flattened the book cost something. Making markets is a business of thousands of these, and of never being caught long into bad news.
Check yourselfA market maker is heavily long and the stock has not moved. What happens to their quote?
Answer once you have one →
Both sides come down. A lower offer makes them likelier to sell; a lower bid makes them less likely to buy more. The mid moves even though nothing about the company changed, which is one reason a single venue’s mid is a poor estimate of fair value in a thin name.
Be able to say this back next week
- Said the business is quoting both sides and ending flat, not predicting direction
- Named adverse selection as the cost the spread must cover
- Explained skewing as an inventory tool, and that it moves the mid without any news
Why Market Maker matters in interviews
Market making is the clearest available example of a business that earns a small edge many thousands of times and is destroyed by being wrong slowly. Trading firms ask about it because the answer reveals whether a candidate thinks in terms of expected value and risk management or in terms of predicting direction. Outside trading, understanding who is on the other side of your fill is what stops an investor from mistaking a thin market for a fair price.
How it works in practice
The economics are volume times edge, minus losses to informed flow and minus the cost of hedging. Because the edge per trade is a basis point or two, the business is only viable at scale and with very low costs, which is why it has consolidated into a small number of technically formidable firms.
Skewing is the day-to-day tool. A maker who has accumulated a long position moves both quotes down: they become more willing to sell and less willing to buy. This is why the mid on a thin instrument reflects dealer positioning as much as fair value, and why a single venue’s mid is a weak estimate of value in an illiquid name.
Designated market makers on some venues and in most options markets carry obligations in exchange for fee rebates or preferential access: to quote continuously, within a maximum spread, for a minimum size. Those obligations are why quotes persist in bad conditions, and their limits are why quotes widen rather than disappear.
The classic interview exercise is not about stocks at all: the interviewer asks you to make a market in something unknowable, such as the number of pubs in a city, then trades against you. What is being tested is whether your spread reflects your uncertainty, whether you update when someone hits you, and whether you manage the resulting position.
What candidates get wrong
- Describing market making as predicting direction. The whole point is to end flat and be paid for immediacy.
- Ignoring adverse selection. Everyone who trades with you chose to; that selection is the central cost of the business.
- Quoting a market too tight in the interview exercise. A narrow spread on a quantity you know nothing about is not confidence, it is a failure to price uncertainty.
- Failing to update after being hit repeatedly on one side. Getting lifted three times in a row is information, and continuing to quote as before is the mistake the exercise is designed to catch.
Market Maker: frequently asked questions
How do market makers make money?
By quoting a price to buy and a price to sell at the same time and capturing the difference. If one buyer and one seller arrive, the maker buys at the bid, sells at the offer, ends with no position and keeps the spread. The edge on any single trade is tiny, so the business depends on very high volume, very low costs, and on the spread being wide enough to cover the trades where the counterparty knew something.
What is adverse selection in market making?
The systematic problem that everyone who trades against your quote chose to do so because your price was attractive to them. Some of those counterparties are trading for reasons unrelated to information, and those are the profitable ones. Others know something the maker does not, and those trades lose money. The spread has to be wide enough that the first group pays for the second, which is why spreads widen ahead of announcements when almost all flow is informed.
Why does a market maker skew their quote?
To manage inventory. A maker who has been sold to repeatedly is short and exposed to a rally they never chose. Raising both the bid and the offer makes them more likely to buy and less likely to sell, which pulls the position back toward flat. The visible consequence is that the mid moves without any change in the underlying company. That is dealer positioning, not new information.
Where Market Maker comes up
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Interview guidesRelated Trading & Markets terms
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