Market Makers

Lesson

Market makers are essential participants in the financial markets, as they provide liquidity and facilitate the smooth functioning of the market. They do this by quoting bid and ask prices for a particular security, effectively "making a market" for that security. Market makers profit from the spread between the bid and ask prices.

Practice Question #1

What is the primary role of a market maker in trading securities?

A) To provide investment advice to clients

B) To act as an intermediary between buyers and sellers

C) To continuously quote bid and ask prices for a security

D) To guarantee the settlement of trades

Select an option above to see an explanation here.

A) Market makers do not provide investment advice to clients. B) Market makers do not act as intermediaries between buyers and sellers; that is the role of brokers. C) Market makers continuously quote bid and ask prices for a security, providing liquidity to the market. D) Market makers do not guarantee the settlement of trades; that is the role of clearinghouses.

Terms

Market Maker:: A firm or individual that actively quotes, bid and ask prices for a security, providing liquidity to the market.
Bid Price:: The highest price a buyer is willing to pay for a security.
Ask Price:: The lowest price a seller is willing to accept for a security.
Spread:: The difference between the bid and ask prices.
Liquidity:: The ease with which an asset can be bought or sold in the market without affecting its price.
Inventory:: The securities held by a market maker to facilitate trades.
Quote:: The bid and ask prices for a security a market maker provides.
Order:: A request to buy or sell a security at a specified price.

Practice Question #2

How do market makers profit from their activities?

A) By charging commissions on trades

B) By earning interest on client deposits

C) By speculating on the direction of security prices

D) By profiting from the spread between bid and ask prices

Select an option above to see an explanation here.

A) Market makers do not charge commissions on trades; that is the role of brokers. B) Market makers do not earn interest on client deposits; that is the role of banks. C) Market makers do not primarily speculate on the direction of security prices; their main goal is to provide liquidity. D) Market makers profit from the spread between bid and ask prices.

Do Not Confuse With

Broker:: An individual or firm that acts as an intermediary between buyers and sellers, usually for a commission.
Dealer:: A person or firm that buys and sells securities for their account rather than on behalf of clients.
Exchange:: A marketplace where securities are bought and sold.

Practice Question #3

Which of the following is NOT a function of a market maker?

A) Providing liquidity to the market

B) Continuously quoting bid and ask prices for a security

C) Acting as an intermediary between buyers and sellers

D) Holding an inventory of securities to facilitate trades

Select an option above to see an explanation here.

A) Providing liquidity to the market is a primary function of market makers. B) Continuously quoting bid and ask prices for a security is a primary function of market makers. C) Acting as an intermediary between buyers and sellers is the role of brokers, not market makers. D) Holding an inventory of securities to facilitate trades is a function of market makers.

Historical Example

In the 1980s, market makers played a crucial role in developing the NASDAQ stock market. By providing liquidity and facilitating trades, they helped the NASDAQ become one of the world's largest and most important stock exchanges.

Practice Question #4

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Example Series 65 Example Practice Question

Real-World Example

A market maker in the stock market might continuously quote a bid price of $50.00 and an ask price of $50.05 for a particular stock. This means that they are willing to buy the stock for $50.00 and sell it for $50.05, profiting from the $0.05 spread.