I was looking into market making and the common idea is market makers make money by capturing the spread. I am a little confused about how this works, since on an exchange if the stock is listed that there are people ready to buy it for x and people ready to sell it for y, market makers have to buy from the exchange and sell it to the end user. According to NBBO , market makers cant charge more than y to sell and more than x to buy. Does anyone have any suggestions ?
Lets construct a simple example that shows a use case of Market Making.
- You're are the only market maker for a very illiquid S&P 500 ETF
- S&P500 Level: 100
- S&P500 Futures Level: 99 / 101
- S&P ETF mid price: 100$
As the only Market Maker your job is to provide the market with liquidity. So you want to set sell and buy prices on the exchange. So what should you do?
To make money and provide liquidity your quotes (sell and buy prices) for the S&P500 ETF could be:
Sell / Buy
95 / 105
If someone want to sell 1 S&P ETF. He will be executed at your limit order @95. To hedge your risk exposure (you are long 1 ETF -> you lose money if the price drops) you short 1 S&P 500 Future @99. In the next hour another market participant comes around and want to buy 1 S&P ETF. You sell it to him @105 and cover your future short.
Whats the profit? Spread Earned - Spread Payed = (105-95)-(101-99) = 8$
Other examples could be taking the risk without a hedge and hope that you could sell your inventory higher as you bought it.