Making a Market

When a firm buys and sells securities for its own account, it is said to be market making. Before a firm can make a market in a security, it has to meet certain Financial Industry Regulatory Authority (FINRA) – formerly the National Association of Security Dealers (NASD) – qualifications with regard to its net capital. These qualification safeguards are designed to ensure that a firm has enough ready capital to back up its quotes so that there's no credit risk in the market.The department that decides which securities to buy and sell and for what prices is called the trading department. Each trader in the department is assigned certain securities to trade. For example, one trader may be responsible for trading over-the-counter (OTC) oil http://www.finweb.com/investing/common-stock.html. During the times that the market is open – on a continual basis – these traders decide what prices their firms will pay to buy and stand ready to sell the securities that they trade.The price at which a firm stands ready to buy a security is known as its bid price. The price that the firm stands ready to sell a security is called its offer or ask price. By both buying and selling a given security, a brokerage firm 'makes a market' in that security. As market conditions change throughout the day, the trader raises or lowers the firm's bid and ask prices. By standing ready to buy or sell securities at their posted prices, these traders perform the same function that specialists and competitive market makers do on an exchange floor. Here's a brief example:Suppose a trader at ABC Brokerage Company is responsible for making the market in OTC computer stocks. For one of these companies, XYZ Computers, Inc., the trader is currently making the market as "31.75 by 32". In other words, the firm stands ready to buy XYZ stock at $31.75 and to sell it for $32.05. Notice that the ask price is $0.30 higher than the bid price. This difference, known as the spread, is where the firm makes its profit. By selling the stock for $0.30 more than it was purchased for, the firm makes a profit of thirty cents on every share that it buys and resells. Therefore, if the price stays constant throughout the day and the trader buys 10,000 shares and also sells 10,000 shares, the firm makes a profit of $3,000.Needless to say, this is a highly simplified example. Ideally, however, traders would like to buy and sell the same number of shares each and every day so that they would not have any overnight inventory to be concerned with. But this is rarely, if ever, the case. If traders are getting more buyers than sellers – that is, having more people buy from them than are selling to them – they compensate by raising the bid and asked prices. This has the effect of attracting sellers and discouraging buyers. Conversely, if they're seeing more sellers than buyers, the traders will lower their bid and ask prices – which is designed to produce the opposite result. Maintaining balance is important so that the trader doesn't get caught with a lot of inventory if the market should turn bad.Traders who don't want to speculate with their firm's capital will always attempt to adjust their bid and ask prices so that they're buying and selling approximately the same number of shares at all times. A sharply rising or falling market generally has little effect unless the trader has build up a substantial long or short position in the security. If the firm is willing to settle for a small profit on each transaction, little market risk is actually involved.