Market makers and high-frequency trading

When you click buy, someone has to be on the other side of the trade. Very often that someone is a market maker, a firm whose business is to stand ready to buy and sell. Alongside them are high-frequency traders, who use speed and automation. Together they shape the spreads and liquidity you see, and both are worth understanding, including their limits.

What a market maker does

A market maker continuously quotes a price at which it will buy (the bid) and a price at which it will sell (the ask). It earns the difference, the spread, on trades that offset each other. In return, it takes on inventory risk: while it holds shares it has bought and not yet sold, the price can move against it.

There are different arrangements:

• Designated market makers on the New York Stock Exchange have obligations to help maintain fair and orderly trading in the stocks assigned to them.
• Registered market makers on Nasdaq and other venues post quotes in the stocks they choose, subject to exchange rules.
• Wholesale market makers are large firms that execute orders sent to them by retail brokers, off exchange.

Competition among market makers helps narrow spreads. Since US stock prices moved from fractions to decimals in 2001, the minimum quote increment for most stocks has generally been one cent, and electronic competition has pushed spreads on large stocks very close to that minimum. See bid, ask, spread and liquidity.

Example (illustrative numbers)

A market maker quotes a stock at $20.00 bid and $20.02 ask. During a busy period it buys 1,000 shares from sellers at $20.00 and sells 1,000 shares to buyers at $20.02.

Gross earnings = 1,000 shares x $0.02 spread = $20

If instead the market maker is holding 1,000 shares when bad news pushes the price down by $0.05, the inventory loses $50, which more than wipes out the $20 earned. Market makers therefore manage inventory carefully, trade many thousands of times, and widen their quotes when conditions are uncertain. This is why spreads widen in stressed markets.

What high-frequency trading is

High-frequency trading (HFT) refers to automated strategies that trade at extremely fast speeds, often with positions held for very short periods and little or nothing carried overnight. Firms invest in fast data, powerful computers, and placing servers close to exchange systems (called co-location).

Common strategies include:

• Market making: quoting both sides electronically, often for many stocks at once.
• Arbitrage: exploiting tiny price differences for the same security across venues, or between related securities.
• Statistical strategies: using models to find short-lived patterns in prices.

Practices meant to mislead, such as placing orders with the intent to cancel them to create a false impression of demand, are known as spoofing and are prohibited.

Payment for order flow

Many retail brokers route client orders to wholesale market makers, who may pay the broker for that flow. Supporters point out that retail orders often receive price improvement, meaning an execution at a better price than the best quote. Critics point to potential conflicts of interest for the broker. Brokers have a duty of best execution and must disclose their routing practices, and regulators periodically review the rules. Both arguments exist, and the practice is one way commission-free brokers can earn revenue.

The benefits and the criticisms

Benefits often cited: tighter spreads, lower trading costs for small orders, and faster execution than in the era of manual trading.

Criticisms often raised:

• Liquidity that can disappear. Automated quotes can be pulled in a split second when conditions turn volatile, which leaves thin books.
• A speed race that smaller participants cannot join.
• Complexity that makes market behavior harder to understand or supervise.

The "flash crash" of May 6, 2010 illustrates the concern. The Dow Jones Industrial Average dropped roughly 9% within minutes and then recovered much of the fall the same day. Many individual stocks briefly traded at extreme prices. Regulators later revised the market-wide circuit breakers and introduced limits on rapid moves in individual stocks. Researchers still debate the exact net effect of high-frequency trading on markets, and the evidence is mixed.

What this means for ordinary investors

• For a large stock in the regular session, you typically trade near the quoted prices and at a very small cost.
• You do not compete on speed. A long-term investor is unaffected by differences that matter over microseconds.
• Liquidity is not guaranteed. In fast markets, thin stocks and extended hours, spreads widen and prices can jump. See market, limit and stop orders for tools that help.
• Your broker's execution quality is worth a look. Brokers publish reports on where they route orders and how well those orders perform.

Common mistakes

• Assuming that every trade is a contest between you and a computer. Most long-term investors' returns are driven by company results and valuation, not by microsecond effects.
• Believing quotes are always firm, particularly in stressed markets.
• Using market orders in thin or volatile conditions.
• Treating a sudden intraday price spike as meaningful information.

For the venues where trading takes place, see NYSE and Nasdaq explained and how stock markets work. For how markets behave under stress, see volatility and the VIX.

Key takeaways

• Market makers continuously quote bids and asks, earn the spread, and bear inventory risk.
• High-frequency trading uses speed and automation, and part of it is market making that narrows spreads.
• Payment for order flow and the net effect of HFT are debated, and both involve trade-offs.
• Liquidity can thin quickly in stressed markets, so limit orders and realistic expectations matter.