Market Making and Liquidity Provision › The Economics of Market Making

You profit by providing a service: immediacy. When a trader wants to buy a stock right now, they don't want to wait for another natural seller to appear. You offer to sell immediately, but at a premium, the ask price. Similarly, when someone wants to sell immediately, you buy at the bid price, which is lower than fair value. This willingness to take the other side of any trade, at any time, is what makes markets function smoothly. Without market makers, traders would face significant delays finding counterparties, and the uncertainty of execution timing would itself become a substantial cost of trading.

Consider a simple example that illustrates the core economics. You quote a stock with a bid of $99.95 and an ask of $100.05. The spread is $0.10. If you buy 100 shares at the bid and sell 100 shares at the ask, the gross profit is:

This calculation is simple. However, several practical complications transform it into an optimization problem:

• Inventory accumulation: Trades don't arrive in perfect alternation. You might buy 500 shares before selling any, accumulating inventory that could lose value if prices move against you. This imbalance is the norm. Order flow is unpredictable, often leading to unintended positions.
• Adverse selection: Some traders have better information about future prices. When an informed trader buys, it often signals that prices will rise, meaning you just sold too cheaply. This information asymmetry is a serious risk in market making because it systematically transfers wealth from you to informed traders.
• Competition: Competition for order flow compresses spreads. In liquid markets, even small inefficiencies can eliminate profit.
• Volatility: Higher volatility means greater risk of price moves between when you buy and sell. A position held for even a few seconds during a volatile period can experience significant adverse price movement.

Understanding these factors allows us to express your expected profit per single trade in a more complete form:

where:

• $s$: bid-ask spread
• Adverse Selection Cost: expected loss to informed traders
• Inventory Cost: cost of holding inventory risk

The factor of $\frac{1}{2}$ appears because you earn half the spread on each side of a trade relative to the mid price. To understand why this is the case, consider that the mid price represents the market's best estimate of fair value. When you buy at the bid, you pay a price that is $\frac{s}{2}$ below the mid price. When you sell at the ask, you receive a price that is $\frac{s}{2}$ above the mid price. Each individual trade therefore generates revenue of half the spread relative to fair value. Successful market making requires setting spreads wide enough to cover adverse selection and inventory costs while remaining competitive enough to attract order flow. This delicate balance defines the central challenge of the market making business.