So what are market makers?

When you first learned that market makers existed, you probably wondered if they were good or bad, and then you probably wondered how they worked.

Market makers are liquidity providers. They help ensure that transactions can easily be entered and exited. They want their delta to be neutral, to do that they need to buy on the offer and sell on the offer. Delta is defined as “the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative”. (Investopedia)

They don’t want to be directional because that would mean they would be Delta Long or Delta Short and they want to maintain their Delta Neutral. Most of the bid/ask spread comes from a lack of Delta neutrality during a lack of liquidity. If the market maker cannot transfer the risk immediately, there is a wider bid/ask spread. If they temporarily lose their Delta neutrality, they will have to generate additional profits in the bid/ask spreads.

It is important to know that the market maker is not bad. Market makers aren’t out to catch you, they don’t chase your stops or try to move the market to make you lose. It’s not you against them because they don’t own stocks or anything. They want to post bids and offers to ensure liquidity is available. If you want to buy it, they will sell it. If you want to sell it, they will buy it.
Market makers make money by buying from people on auction and selling to people on demand.

However, competitions between traders and market makers on the same exchange will help traders more than if traders and market makers were spread across multiple exchanges. More market makers and traders means more benefits for both. If there are more market makers, there will be more liquidity for traders, which will attract more traders to the exchange, allowing more positions to be bought and sold.

Market makers want to offload their risk so badly that they are scrambling to do so. This brings the bid/ask spread closer and closer. To clarify, the bid/ask spread is the difference between the bid price and the bid or ask price. If the bid is 53 and the ask is 57, the difference is 4. If you were to buy a contract at 57, you would have to sell at 53 in order to exit the trade immediately, resulting in a loss of $4. Similarly, if you were selling at 53 and wanted to exit the trade immediately before the market moved, you would need to repurchase the contract at the price of 57 to exit the trade. That’s another $4 loss. By reducing the bid/ask spread difference, you limit your loss, which can represent substantial savings.

Let’s look at a scenario of how it all works:

Suppose the bid is 53 and the ask is 57. A trader has sold at 53 and market maker A has been filled at the bid price causing him to buy the contract. It will lose its neutral Delta position if the market falls.

Market makers A and B both have a quote of 57 on the bid or are asking them to sell to a buyer. Remember that market makers like to stay neutral on Delta and since market maker A bought the contract, he is long on Delta, which he doesn’t want. Market maker A goes ahead of market maker B placing a sell offer to a buyer at 56. He “stumbles” on market maker B to ensure he gets the fill if a trader takes the other side.

However, if market maker B also needs to offload contracts, they can override market maker A by placing a sell offer at 56, further narrowing the gap between the offer and the offer. offer.

Now suppose there are other market makers and traders. This will further tighten the bid/ask spread. The more traders and market makers there are on the exchange, the more orders are filled. They all seem to want to hedge against the trade, which narrows the gap between supply and demand even further.

By tightening the spread between bid and ask, it limits the amount of loss shown on profit and loss when you enter your trade. Instead of automatically being down $5-8, you can only be down a dollar or two. Sometimes the gaps are so tight; there is no difference.

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