Market makers play a crucial role in financial markets, but what exactly do they do? Here’s what investors need to know about these important middlemen.
Providing Liquidity
Market makers facilitate trading by continuously quoting a bid and ask price on securities and derivatives like options. This provides liquidity that allows investors to enter and exit positions.
Acting as middlemen, market makers stand ready to buy or sell at their quoted price. They profit on the bid-ask spread while absorbing some risk.
Bearing The Risk
After selling an option contract for example, the market maker is then exposed to potential losses if the price moves against them. Managing this risk is key.
To hedge, market makers enter additional trades that offset their exposure. Success depends on accurately calculating options prices and managing risk positions.
Predicting Volatility Is Vital
The better a market maker’s forecast of future volatility, the better they can price options and manage hedges. More accurate volatility predictions mean more profitable trades.
That’s why expected volatility is a crucial input in options pricing models. If implied volatility is higher than realized volatility, the market maker may lose.
Providing An Essential Service
By facilitating orderly markets and liquidity, market makers bring significant value to the financial system. Investors rely on their continuous quotes and willingness to trade.
In exchange for bearing risk, market makers get to pocket the bid-ask spread as compensation. It’s a win-win for traders and investors alike.
