What Is a Market Maker ?
A market maker is a participant in the market who provides liquidity by placing limit orders on the order book. They do this by continuously buying and selling assets to maintain an active market. Market makers typically profit from the spread—the difference between the buying price (bid) and the selling price (ask). They usually place orders slightly below the current market price (bid) and slightly above it (ask). Market makers help ensure that there are always buyers and sellers in the market, facilitating smoother trading and tighter bid-ask spreads.
Imagine you're a market maker trading Bitcoin on an exchange. Your goal is to provide liquidity to the market by continuously quoting bid and ask prices for Bitcoin. Here's how it works:
1. Placing Orders: You place limit orders on the order book to buy and sell Bitcoin. For example, you might place a bid to buy Bitcoin at $40,000 and an ask to sell Bitcoin at $40,050. These orders are typically placed slightly above the highest bid and slightly below the lowest ask to capture the spread.
2. Maintaining Liquidity: As the market moves, you adjust your orders to reflect the changing price dynamics. If the price of Bitcoin rises, you might adjust your bid to $40,010 and your ask to $40,060. By continuously updating your orders, you ensure that there are always prices available for traders to buy and sell Bitcoin.
3. Profiting from the Spread: You make money from the spread—the difference between the bid and ask prices. In our example, if a trader buys Bitcoin from you at $40,050 and immediately sells it back to you at $40,010, you earn a profit of $40 per Bitcoin. This profit compensates you for providing liquidity to the market.
4. Managing Risk: As a market maker, you also need to manage your risk exposure. If the price of Bitcoin moves against your position, you may incur losses. To mitigate this risk, you might use hedging strategies or adjust your position size based on market conditions.
Overall, as a market maker, your role is to provide liquidity to the market.