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 this works 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 (also 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.
The 4x7 shows the quote size in round lots.
The market maker’s profit comes from the difference between the buy price and the sell price.
A $1 spread is not typical for actively traded stocks. Most popular stocks have spreads measured in pennies. Even with small spreads, firms can earn substantial profits if trading volume is high.
An efficient market is one with active trading and small spreads. In an efficient market, market makers can rely on many small spreads adding 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.
Bid
Ask
Operating in some form since 1792, the New York Stock Exchange (NYSE) is the world’s largest stock exchange. The NYSE is an auction market. For each listed stock, a designated market maker (DMM) (sometimes called a specialist) facilitates trading.
Like an auctioneer, the DMM:
In any given trade, the DMM may act 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 practice, the DMM function is a mix of people and technology.
Private companies are hired by the NYSE to operate as DMMs, and they assign an employee to the DMM post on the exchange floor. If you want a deeper look, here’s a NYSE 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 main 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.
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 the current limit orders on the book.
The last completed trade was 500 shares at $40.25, which sits between the highest bid and the lowest ask.
These best prices form the inside market, meaning the best available bid and best available ask 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. A market order requests execution at the next available price.
If the DMM believes the $0.50 spread (between the highest bid and lowest ask) is too wide, the DMM may step in and fill the market order at a better price.
This is a common way DMMs act in a principal capacity: instead of matching orders on 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:
Doing so would mean trading ahead of (or “in front of”) public orders already on the book.
Putting it together:
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 temporarily freeze (guarantee) a price 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 orders to the NYSE.
For example, Charles Schwab could send a representative to the NYSE floor to help execute large customer trades (small trades are typically handled electronically). If Schwab receives a large order in an NYSE-listed stock, it may route that order to a floor broker.
From there:
DMMs can only stop stock for public orders. They can’t stop stock for themselves or for a firm’s proprietary 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 you should know that the NYSE generally lists large, actively traded companies.
The NYSE isn’t the only exchange with this structure. Other exchanges are modeled similarly, including the American Stock Exchange, referred to as NYSE-MKT. There are also regional exchanges with similar features, 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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