The bid-offer spread is the difference between the highest bid and the lowest offer in the market. A market is said to be liquid if the number of buyers and sellers in the market is large, and the bid-offer spread is small. Investors trading in liquid markets benefit from reduced transaction costs and the ability to unwind their positions at any time.
In times of increased market volatility, a liquid market can rapidly become illiquid. The bid-offer spread can widen tremendously, or a market can become one-side (for example, there are only sellers but no buyers). Even under normal conditions, some products don’t attract enough buyers and sellers at the same time for the product to be liquid.
BALANCE THROUGH MARKET MAKERS
To solve this problem, exchanges ask market makers to participate. Market makers are professional traders who have no directional opinion on the products they trade. They concurrently post a bid and an offer in the products they trade. Often, multiple market makers participate in the same product, and this serves to create a continuously available, liquid market for investors. The bid-offer spread narrows and therefore transaction costs for investors decreases. Market makers are sometimes required by the exchange to continue making two-sided markets regardless of market conditions, and are oftentimes the only source of liquidity for investors.
TECHNOLOGY, ALGORITHMS, AND MODELS
Market makers look to make a small profit on the trades they make. As competition increases, bid-offer spreads get tighter, and the profit margins for a market maker decrease. In order to stay profitable, market makers must participate in thousands of products and trade tens of thousands of contracts daily. This can only be achieved through sophisticated technology, algorithms, and financial models.
Option Market Making
Options are a natural fit for market makers. Often, for just one underlying (a stock, ETF, index, or futures contract), an exchange will list hundreds or thousands of options with different strike prices and maturities. Without market makers, these contracts would be completely illiquid, often with no buyers or sellers at any given time. Options exchanges rely almost solely on market makers to create liquid markets for their products.
For the market maker, trading options adds an additional layer of complexity. Options are risky instruments that have exposure not only to movements in their underlying, but to changes in market volatility, dividends, and interest rates. Since options are inherently illiquid, market makers are often required to carry positions on their books for long periods of time. Since market makers have no opinion on market direction, they hedge the risks associated with an options position by trading the underlying, interest rate derivatives, options of a different strike or maturity, or even options on different but correlated products. To accomplish this, an option market maker must build & maintain sophisticated financial models and risk management tools.