Online traders, and especially swing traders and position traders who want to trade immediately, need to be aware of organizations that function as market makers.
Here's a practical definition of market makers: they are registered traders, usually of brokerage firms, that agree to post prices on both sides of the market, buying and selling.
These are often shown in stock listings as bid and ask. Bid and ask are price tags on a stock, as it waits to be bought or sold.
"Market makers sign a contract with a stock exchange saying they will always be there to provide a market for a particular stock," says Jim Bittman, a senior instructor at the Chicago Board Options Exchange, and 30-year veteran of the trading industry.
"The responsibility of market makers is to assure liquidity on stock markets," says Francesco Pasin, CEO of Montreal-based JitneyTrade, and a 16-year veteran of the trading industry.
Market makers are important for individual online traders in two ways.
"First, if online traders want to buy stock, there is always stock to buy from market makers," says Pasin.
"Second, if online traders want to sell stock to unlock their profits, there are always market makers to sell to. That's very important; profits are theoretical until they are sitting in your cash account," says Pasin.
There are about 300 market makers altogether in Canada.
The New York Stock Exchange only has one market maker per stock, who works on the actual trading floor. He or she handles huge orders, say 100,000 shares of a stock, for a hedge fund or pension fund.
Represented by colourful jackets on the NYSE, market makers doing the big deals are still on the trading floor. They're the ones you see on CNBC interviews every day and also the ones that Hollywood likes to glamourize in movies like Trading Places. Alas, they are a dying breed as markets like the NASDAQ and the TSX have gone electronic.
Small orders from individual "retail" traders go through a computer system which is designed to match those orders. But if no other investor wants to buy your stock, or sell you more, the market maker steps in. "Online traders do not always trade with market makers. Frequently, online traders trade with market makers, but not always. There are other people participating in the market," says Bittman.
How do market makers make money?
In return for the liquidity they provide to stock markets, market makers make profits on the spread – and move on to the next trade.
Pre-1996, in the case of the TSX, the stock exchange used a fractional system of pricing. The fractional system was based on eighths of a dollar, so the smallest increment was 12 1/2 cents and spreads used to range from 12 1/2 to 50 cents on a stock. In 1996, the TSX switched to a decimal system and other stock exchanges followed. Technology and more competition have narrowed spreads.