Investors buy and sell securities in the market thanks to the role market makers play. These are entities that make a business out of trading securities with the public. Like a car dealership does with cars, a market maker buys securities from investors and resells those securities back to other investors.
In this chapter, we’ll discuss the bid and ask spreads utilized by market makers and how they operate in two big markets.
Bid & ask (offer) spreads are maintained by market makers in the secondary market*. The bid and ask represent prices they are willing to trade at.
*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 term ‘bid’ comes from the perspective of the market maker. The firm is “bidding” on the security in the market in hopes of a customer showing up and selling. In addition to the bid price, the market maker also specifies how many shares they’re willing to buy at that price. We’ll discuss this later in this section.
The ask, sometimes referred to as the “offer,” represents the price the firm is willing to sell a security at. Again, the term ‘ask’ comes from the perspective of the market maker. The firm is “asking” a price for the security in the market in hopes of a customer showing up and buying. In addition to the ask price, the market maker specifies how many shares they’re willing to sell at that price.
Here’s an example of a bid/ask:
GM stock
$40 bid / $41 ask
4x7
In this example, we have a market maker for GM stock. According to the bid, they are willing to buy up to 400 shares of GM stock at $40 from the public. When a market maker publishes a quote, they signify how many round lots they’re willing to buy or sell with the public. With 4 on the bid side, it tells us they’re willing to buy 400 shares at the bid price specified.
According to the ask, the market maker is willing to sell up to 700 shares of GM stock at $41. The difference between the market maker’s buy price of $40 and sell price of $41 is how they make a profit. Often referred to as the “spread,” this $1 difference can add up as market makers are known for performing thousands of trades daily.
A $1 spread is not common with actively traded stocks. In most cases, popular stocks have spreads in the pennies. In an efficient market, financial firms make substantial profits even with small spreads. An efficient market is defined as one with active trading and small spreads. As long as the market maker trades enough with the public, these small spreads tend to add up over the day.
There are always two sides to a trade. We’ve discussed the bid and ask through the perspective of the market maker. When a customer is involved, they take the opposite side of the trade. Here’s a summary of the two sides of the bid/ask:
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 referred to as the ‘Specialist’) facilitates all trading for a stock. Similar to how any other auction works, the DMM (auctioneer) matches buyers with sellers, but also trades with the public out of their inventory. In any given trade, they can operate in an agency or principal transaction*.
*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 reality, the DMM is both a person working on the floor of the NYSE and a glorified computer system. The speed of the financial markets in today’s digital age makes it impossible for any human to manually execute all trades as a market maker. Most market makers in the financial markets are run by complex digital programs and algorithms that react nearly instantaneously to changes in the market. However, there still are people behind the scenes that ensure trading systems work properly and step in to manually trade if needed. Private companies are hired by the NYSE to operate as DMMs, who then send a select employee to operate the DMM post. If you’re really interested, here’s a link to a NYSE-created YouTube video describing the role of DMMs.
There are several DMMs on the NYSE, but each listed stock is handled by one DMM. For example, all trades of Coca-Cola stock (listed on the NYSE) are facilitated by one specific DMM. The primary goal of the DMM is to “maintain fair and orderly markets” and minimize any potential liquidity problems. In plain English, their job is to make sure investors can trade at accurate market prices at any time (during normal business hours).
There are several ways the NYSE accomplishes this task. First, there’s a complex routing system traditionally referred to as the Super Display Book. When financial firms submit customer orders to the NYSE, most orders go through this system, which directs the order to the DMM for execution. In 2012, the Super Display Book system was updated to the modern Universal Trading Platform, but FINRA still refers to the Super Display Book as the NYSE’s system to this day.
Limit orders 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 better understand this, let’s look at a basic example of what the DMM’s book could look like:
When a DMM looks at market dynamics, they’ll pull up a screen looking something like this. For the most part, it’s a complex bid & ask system. The left side represents all buy limit orders placed by financial firms on behalf of their customers (the IDs represent the firms submitting the order; you don’t need to know IDs for specific firms), while the right side represents all sell limit orders. All of these orders are currently “away from the market,” meaning they cannot be filled with the current market price. The last completed trade was for 500 shares at $40.25, which is in between the highest bid and lowest ask.
The best buy order is for 100 shares at $40.00, while the best sell order is for 300 shares at $40.50. This is the inside market, which represents the best available prices currently on the DMM’s book. Therefore, the inside market is:
40.00 x 40.50
1 x 3
Market orders are often matched against the limit orders on the book. Click the link above for the details, but these are orders requesting a trade at the next available price. If a market order to buy 300 shares came into the system, it could be matched against the trade placed on the book at $40.50. In this instance, the DMM acts in an agency capacity by matching a buyer (the market order to buy) with a seller (the $40.50 limit to sell).
If the DMM felt the $0.50 cent spread (between the highest bid and lowest ask) was too much, they could step in and fulfill the market order at a better price than $40.50. Let’s assume the DMM sells 300 shares from their inventory at $40.40, which is a $0.10 per share price improvement over the limit order to sell 300 shares at $40.50. This is how DMMs primarily operate in principal capacities. Instead of matching market orders against their book, they step in and buy shares into or sell shares from their inventory. The only requirement they must follow is to avoid competing with public orders. For this example, this means they cannot sell shares from inventory for $40.50 or higher or buy shares into their inventory for $40.00 or lower. If they did, they would be trading in front of the public orders on their book.
The last few paragraphs detail how the DMM carries out its goal of maintaining a fair, orderly, and liquid market. If enough investors are trading in the market, they’ll step aside and match buyers and sellers (agency). If there’s a lack of trading or a large spread, they’ll step in and trade directly with public customers (principal).
Here’s a video that dives further into DMM’s role with bid and ask spreads and how to approach test questions on the topic:
DMMs are also authorized to stop stock, which freezes the price of a security for a short amount of time. This is most often done for floor brokers, which also roam the floor of the NYSE. Floor brokers work on behalf of financial firms that send trades to the NYSE.
For example, Charles Schwab could send a representative to the floor of the NYSE to facilitate large trades for its customers (small trades are routinely handled by the system with no human input). If Charles Schwab received a large order for an NYSE-listed stock from a customer, the trade could be sent to the floor broker. From there, the floor broker would talk with the DMM and other floor brokers to find the best possible price for the customer. If the DMM felt inclined to do so, they could quote a price to the floor broker and “lock it in” (stop the stock) for a short amount of time. For that short period of time, the floor broker will attempt to find a better price among other brokers. If a better price isn’t found by the end of the time period, they’ll go back to the DMM and take them up on their offer. DMMs can only stop stock for public orders; they cannot do it for themselves or for a financial firm’s trading account.
The NYSE only trades stocks that are “listed” on the exchange. To be listed, issuers must meet certain characteristics, like market capitalization and minimum numbers of shareholders. You don’t need to know these listing requirements, but you should be aware that only the largest companies with the most actively traded stocks are traded on the NYSE.
The NYSE isn’t the only exchange that works the way it does. In fact, there are a few other exchanges that are modeled after the NYSE’s structure. There’s the American Stock Exchange, referred to as NYSE-MKT, which is also a large national exchange. Additionally, there are regional exchanges that are similar to the NYSE, like the Philadelphia Stock Exchange. It’s possible that a stock may trade on the NYSE and another exchange, typically a regional one. These are referred to as dual-listed stocks.
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