How Market Makers Earn the Bid-Ask Spread and Manage Inventory Risk
Summary
Market makers stand ready to buy from sellers and sell to buyers, providing immediacy when natural counterparties are not available at the same time. They quote a bid, the price at which they will buy, and an ask, the price at which they will sell. The gap between these quotes can compensate them for supplying liquidity and bearing the risk of holding assets while prices move.
The discussion connects this basic role to market microstructure. It identifies inventory-based explanations of spreads and models in which dealers account for the possibility that trades come from better-informed participants. It also uses familiar dealer settings as an analogy for bids and asks. The thread offers a conceptual overview rather than a quantitative strategy: it does not specify quote placement, inventory controls, or profitability after fees and adverse price moves.
Key ideas
- A market maker provides liquidity by standing ready to buy and sell.
- The bid is the dealer's buying price, while the ask is the selling price.
- The spread can compensate for immediacy provision and the risks of holding inventory.
- Market microstructure explains spreads through inventory costs and information asymmetry.
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Full text
# Market making: buy on bid/sell on ask # Market making: buy on bid/sell on ask In this thread, the top answer discusses: "`buy on bid, sell on ask`" as "`market making`" strategies. My question is: - In layman terms, what does "`buy on bid, sell on ask`" mean? - Why are these techniques called "`market making`"? ## Answer by Shane (score 10, accepted) https://quant.stackexchange.com/a/9258 Most organized markets have intermediaries to match buyers and sellers who may arrive at different rates. These intermediaries are typically called market makers because they "make markets" by buying from people who want to sell and selling to people who want to buy. Since market makers take on risk to provide liquidity, they generally need to be compensated for their services. This compensation usually comes in the form of what's called the "bid/ask spread". A market maker will buy at the bid price and sell at the ask (or offer) price. These liquidity providers can thus earn a return by providing immediacy to impatient traders. See Harold Demsetz (1968) "The Cost of Transacting" for an early reference on this subject. There is an extensive field to explain this field known as "market microstructure". As I discussed in the past, there were traditionally two major types of models for explaining the spread within this literature: asymmetric information based models and inventory models. Inventory models were originally derived from Garman (1976). Asymmetric information models have received the most attention recently; there are two standard frameworks: the "sequential trade framework" by Glosten and Milgrom (1985) and the "strategic trade framework" developed by Kyle (1985). ## Answer by James Lin (score 2) https://quant.stackexchange.com/a/9328 There are numerous examples of "market making" outside of finance a layman might relate better to. A "market" is simply a place that stands ready to make a buy/sell transaction on a product. In real life they are usually just called "dealers" and you often encounter them when you are visit a used car dealer, concert tickets scalpers or pawn shops. The price they quote to pay for an item is the "bid", and the price quote to sell an item is the "ask". Market maker by creating a "market" makes it for easier for customers to transact, and they also create price discovery by balancing out buys and sell orders. For this service they are compensated by the bid-ask spread. The main risk market makers take is holding inventory that may lose value.
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