Market Makers, How They Earn from Spreads and Where the Risk Comes From?

The condition is one and only!!! For trading to continue, someone must keep posting prices.

What exactly is a market maker?

A market maker is a participant who continuously posts bid and ask quotes to supply liquidity to the market.

Retail investor:

"Can we just trade without them?"

No.

If trading suddenly stops, price volatility increases.

Why is liquidity so important?

Liquidity makes buying and selling easy and prices move smoothly.

With low liquidity, a single order can swing prices widely.

The bid ask spread, that is the key.

Bid ask spread → the difference between buy and sell quotes.

The spread reflects immediate trading costs and the level of liquidity.

A narrow spread signals low trading costs and good liquidity.

Why do market makers earn money?

The important thing is the spread.

They capture the difference between buy and sell as profit.

Here is a simple numerical example.

Example setup: the market maker quotes near the market price for one share.

Bid: 9,900원

Ask: 10,100원

Spread: 200원

This spread is the potential profit source for the market maker each time a counter trade happens.

Scenario 1: assume consecutive trades of one share each occur.

If the market maker posts buy at 9,900원 and sell at 10,100원

they effectively buy at 9,900원 from sellers and sell at 10,100원 to buyers.

Profit per matched pair = 10,100원 - 9,900원 = 200원.

If they handle 500 such pairs in a day, revenue = 200원 × 500 = 100,000원.

But there is risk.

In rapid price moves, inventory (held shares) can be revalued unfavorably and cause losses.

Example: if 1,000 held shares drop sharply by 10% the valuation loss = 1,000 shares × (10,000원 × 10%) = a large loss.

Therefore market makers constantly balance spread earnings against position risk.

Common misconception 1: "Market makers always make money"?

No.

Liquidity provision can incur losses from rapid price swings and inventory revaluation.

Common misconception 2: "A small spread means an objectively good market"?

A small spread lowers trading costs but liquidity providers can withdraw quickly under stress.

In thin markets it is normal for spreads to widen.

Common misconception 3: "Market makers are illegal manipulators"?

Legitimate market makers operate under regulation with disclosure and obligations while supplying liquidity.

How do they operate, what are the steps?

→ Step 1: continuously submit quotes to build buy and sell queues.

→ Step 2: manage inventory and hedge when trades occur.

→ Step 3: widen spreads in volatile situations to control risk.

So, what to check first

→ 1. Look at the quoted spread, a narrow spread indicates good liquidity.

→ 2. Check trade frequency and volume, higher frequency means a more active market.

→ 3. Observe patterns of order cancelation and spread widening during shocks, these are risk signals.

For reference only.

PickStock 💡

※ Investment decisions and responsibility rest with the investor.

※ Figures are as of the time of writing and may change.

※ This article is for information purposes and is not investment solicitation.