Investors can buy and sell securities in the secondary market largely because of market makers. A market maker is a firm that makes a business out of trading securities with the public. Like a car dealership that buys cars and resells them, a market maker buys securities from investors and sells those securities to other investors.
This chapter explains how market makers use bid and ask spreads and how they operate in two major markets.
Bid & ask (offer) spreads are maintained by market makers in the secondary market*.
*Securities are originally sold in the primary market by issuers, then are traded in the secondary market by investors.
The bid is the price the firm is willing to buy a security at.
The ask, sometimes called the offer, is the price the firm is willing to sell a security at.
Here’s an example of a bid/ask:
GM stock
$40 bid / $41 ask
4x7
In this example, a market maker is quoting GM stock.
When a market maker publishes a quote, the size is shown in round lots. The “4” on the bid side means 4 round lots, or 400 shares.
The market maker’s profit comes from buying at the bid and selling at the ask. The difference between $40 and $41 is the spread. Even small spreads can add up because market makers may execute thousands of trades per day.
A $1 spread is not common for actively traded stocks. Popular stocks often have spreads measured in pennies. In an efficient market, firms can still earn substantial profits because trading volume is high and spreads are small.
An efficient market is defined as one with active trading and small spreads. As long as the market maker trades frequently with the public, small spreads can add up over the day.
There are always two sides to a trade. So far, we’ve described bid and ask from the market maker’s perspective. A customer takes the opposite side.
Here’s a summary:
Bid
Ask
Functioning in some form since 1792, the New York Stock Exchange (NYSE) is the world’s largest stock exchange. The NYSE operates as an auction market, where a designated market maker (DMM) (sometimes called a specialist) facilitates trading in a stock.
Like other auctions, the DMM (acting like an auctioneer) matches buyers with sellers. The DMM may also trade with the public out of the DMM’s own inventory. In any given trade, the DMM can act in an agency or principal capacity*.
*These trade capacities are discussed in detail later in this unit. For now, assume an agency capacity involves matching buyers and sellers, while a principal transaction involves a professional trading directly with their clients.
In practice, the DMM function is both a person on the NYSE floor and a technology-driven trading system. Modern markets move too quickly for a human to manually execute every trade, so market making relies heavily on computerized systems and algorithms that respond almost instantly to changing prices and order flow. People still oversee these systems and may step in to trade manually when needed.
Private companies are hired by the NYSE to operate as DMMs, and they assign an employee to work at the DMM post. If you want a closer look, here’s an NYSE-created YouTube video describing the role of DMMs.
There are several DMMs on the NYSE, but each listed stock is assigned to one DMM. For example, all trades of Coca-Cola stock (listed on the NYSE) are facilitated by one specific DMM.
The DMM’s primary goal is to maintain fair and orderly markets and reduce liquidity problems. In plain terms, the DMM helps ensure investors can trade at accurate market prices during normal trading hours.
One way the NYSE supports this is through its order-routing system, traditionally called the Super Display Book. When firms submit customer orders to the NYSE, most orders go through this system and are routed to the DMM for execution. In 2012, the Super Display Book was updated to the modern Universal Trading Platform, but FINRA still refers to the Super Display Book as the NYSE’s system.
Limit orders that are currently “away from the market” are placed on the NYSE’s order book, known as the DMM’s book.
*Limit orders involve placing a “limit” on a transaction price. For example, a limit order to buy stock at $40 would not allow a transaction to go through unless the stock was $40 or lower. If the market price was above $40, the order would be “away from the market” and remain unfilled until the market price fell below $40. You’ll learn more about these order types later in this unit.
To see how this works, here’s a simplified example of what the DMM’s book might look like:
This screen shows a bid-and-ask style view of limit orders.
The last completed trade was 500 shares at $40.25, which sits between the highest bid and the lowest ask.
This is the inside market: the best available prices currently on the DMM’s book. So the inside market is:
40.00 x 40.50
1 x 3
Market orders are often matched against limit orders on the book. (A market order requests execution at the next available price.)
For example, if a market order to buy 300 shares enters the system, it could be matched against the $40.50 limit order to sell 300 shares. In that case, the DMM is acting in an agency capacity by matching:
If the DMM believes the $0.50 spread (between the highest bid and lowest ask) is too wide, the DMM can step in and fill the market order at a better price than $40.50.
Assume the DMM sells 300 shares from inventory at $40.40. That gives the buyer a $0.10 per share price improvement compared with buying at $40.50. This is a common way DMMs act in a principal capacity: instead of matching orders from the book, they trade directly from their own inventory.
When doing this, the DMM must avoid competing with public orders. In this example, that means the DMM cannot:
Doing so would mean trading in front of the public orders on the book.
These examples show how the DMM supports a fair, orderly, and liquid market:
Here’s a video that goes deeper into the DMM’s role with bid and ask spreads and how to approach test questions on the topic:
DMMs are also authorized to stop stock, meaning they can freeze the price of a security for a short period of time. This is most often done for floor brokers, who work on the NYSE floor.
Floor brokers represent financial firms that send trades to the NYSE.
For example, Charles Schwab could send a representative to the NYSE floor to help facilitate large customer trades (while small trades are routinely handled electronically). If Schwab receives a large order in an NYSE-listed stock, the order could be routed to a floor broker. The floor broker may then work with the DMM and other floor brokers to find the best available price.
If the DMM chooses, the DMM can quote a price to the floor broker and “lock it in” (stop the stock) for a short time. During that time, the floor broker tries to find a better price from other brokers. If no better price is found before the time expires, the broker can return to the DMM and accept the quoted price.
DMMs can only stop stock for public orders. They cannot stop stock for themselves or for a firm’s trading account.
The NYSE trades only stocks that are listed on the exchange. To be listed, issuers must meet certain standards (such as market capitalization and minimum numbers of shareholders). You don’t need to memorize the listing requirements, but it’s important to know that the NYSE generally lists large companies with actively traded stocks.
The NYSE isn’t the only exchange organized this way. A few other exchanges are modeled after the NYSE structure, including the American Stock Exchange, referred to as NYSE-MKT. There are also regional exchanges similar to the NYSE, such as the Philadelphia Stock Exchange.
A stock may trade on the NYSE and another exchange (often a regional exchange). These are called dual-listed stocks.
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