There are different types of traders. Some trade stocks, some trade options, some trade futures. Some hold their assets for a long time (think months to years) and some hold their assets for a very short time (think seconds and minutes). There are many, many different types of traders, the list can go on and on. In this post, I'd like to focus on the group I used to belong to -- market makers.
A market maker is a liquidity provider. In other words, a market maker provides the marketplace (other traders) with markets (a bid/ask spread).
Imagine a market with no market makers. Parties that want to buy a certain instrument cannot until they are approached by someone else who wants to sell it. Trades wouldn't happen as often as the liquidity dries up. The trades that do happen will most likely introduce inefficiencies to the market as parties waste time and resources to find the right contract and price.
The job of a market maker is to bridge this gap between buyers and sellers by constantly providing a bid and an offer. By doing so, the market maker accepts the risk of holding a certain number of open positions (whether you're long or short) of a particular contract in order to facility trading. However, given its role, a market maker does not have a directional bias on whether the prices will raise of fall. Direction neutrality is inherent in the very nature of market making. This bias can be seen in market makers' attempt to keep a risk minimized portfolio.
There are advantages and disadvantages. Let's explore some.
Depending on the exchange he trades on, a market maker will have obligations he needs to fill. For instance, he might always have to provide a bid and offer of a certain size and the width of that market (the bid-ask spread) cannot be wider than a certain width. If a market maker breaks some of these rules, he can be fined.
On the flip side, some exchanges offer cheaper fees to market makers. (In fact, this topic of fees warrants an entire post for itself). And given that a trader does a significant amount of trades, these fee discounts (or sometimes even rebates) can generate significant profits.
A disadvantage of a market maker is getting run over. Since the market maker generally has to provide tight markets, he is exposed to large movement risks (sometimes called being run over). For instance, if a market maker offers 10 lots at 4.00 (say while bidding 3.95 on 10 lots) when a large buyer comes and buys 1,000 lots and the price gets moved up 4.30. Suddenly, the sell at 4.00 is a huge loss.
On the other hand, since the market maker is providing a relatively tight bid and offer, he is expected to make a profit just off the spread. For example, let's again go to the market maker who is 3.95 at 4.00, 10 up, when a buyer comes in and purchases 10 lots for 4.00 (which means the market maker sells 10 lots at 4.00). Almost immediately, a seller comes in and sells 10 lots at 3.95 (here, the market maker pays 3.95 for 10 lots). As a market maker, he effectively just bought for 3.95 and sold it at 4.00, result in flat position and long cash (not holding onto any risk and only holding onto profits).
In the next post, I will go through a long example of how market making one security might play out throughout the day.