In this thread, the top answer discusses: "buy on bid, sell on ask" as "market making" strategies.
My question is:
- In layman terms, what does "
buy on bid, sell on ask" mean? - Why are these techniques called "
market making"?
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1$\begingroup$ FYI, that answer has things reversed. Market makers buy at the bid and sell at the ask because they are passive traders. Buying at the ask, or lifting the offer, means you are aggressively taking liquidity and crossing the spread. $\endgroup$– Louis MarascioCommented Oct 25, 2013 at 11:59
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2$\begingroup$ You're going to attract a lot of negative attention by asking for "laymen's terms" definitions of simple concepts. This site is meant for professionals who practice quantitative finance on a daily basis. $\endgroup$– Joshua UlrichCommented Oct 25, 2013 at 20:09
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1$\begingroup$ @LouisMarascio Wow...I didn't even notice that was reversed. That's insane. Would be nice if everyone did a little googling before asking a question. $\endgroup$– ShaneCommented Oct 26, 2013 at 1:47
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$\begingroup$ @Shane I've already suspended this user. In the span of one day he's asked how stock prices are determined, what the limit-order book is, and how HFT adds to liquidity. $\endgroup$– chrisaycockCommented Oct 26, 2013 at 2:14
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2 Answers
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Most organized markets have intermediaries to match buyers and sellers who may arrive at different rates. These intermediaries are typically called market makers because they "make markets" by buying from people who want to sell and selling to people who want to buy.
Since market makers take on risk to provide liquidity, they generally need to be compensated for their services. This compensation usually comes in the form of what's called the "bid/ask spread". A market maker will buy at the bid price and sell at the ask (or offer) price. These liquidity providers can thus earn a return by providing immediacy to impatient traders.
See Harold Demsetz (1968) "The Cost of Transacting" for an early reference on this subject.
There is an extensive field to explain this field known as "market microstructure". As I discussed in the past, there were traditionally two major types of models for explaining the spread within this literature: asymmetric information based models and inventory models. Inventory models were originally derived from Garman (1976). Asymmetric information models have received the most attention recently; there are two standard frameworks: the "sequential trade framework" by Glosten and Milgrom (1985) and the "strategic trade framework" developed by Kyle (1985).
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There are numerous examples of "market making" outside of finance a layman might relate better to. A "market" is simply a place that stands ready to make a buy/sell transaction on a product. In real life they are usually just called "dealers" and you often encounter them when you are visit a used car dealer, concert tickets scalpers or pawn shops. The price they quote to pay for an item is the "bid", and the price quote to sell an item is the "ask". Market maker by creating a "market" makes it for easier for customers to transact, and they also create price discovery by balancing out buys and sell orders. For this service they are compensated by the bid-ask spread. The main risk market makers take is holding inventory that may lose value.
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$\begingroup$ A layman outside of finance is the exact opposite of what we want here. $\endgroup$ Commented Nov 1, 2013 at 13:09