Most investors in the stock market know what a stock is but don’t understand how the “market” itself works. Understanding how a market works is helpful to appreciate both how and why prices fluctuate.
I mentioned last week that my grandfather Donald Mortlock worked on Wall Street during and after the 1929 crash. The firm he worked for was a “market maker,” a company which helped to literally “make a market” in several stocks. One such stock was the American Can Company which thought it could actually make money selling food packaged in a can!
A market maker is a firm that stands ready to buy or sell a particular stock on a regular and continuous basis at a publicly quoted price. Market makers still exist today and play a key role in keeping a stock exchange -just that- an exchange.
Take for example the company General Electric (the only original component of the Dow still in the index). A market maker for GE stock is required to buy shares of GE from investors wishing to cash in on their shares. They also have to sell shares of GE at a slight markup as necessary during the trading day.
Imagine if everyone in the country who owned GE stock had to list a price at which they would be willing to sell their stock. Some people would list a very high price and others would list a more reasonable value. Now, imagine everyone in the country also had to list a price at which they would be willing to buy GE stock. Some people might only be willing to accept GE stock for free, while others would list a more reasonable value.
Without a market maker, buying the stock would be similar to shopping on eBay. If you wanted to purchase shares of GE stock, you would first have to find a seller with an ask price you thought was reasonable. Then, you would have to ensure that buyer could offer you enough shares to fulfill your order. Who knows, at the last minute, another investor could come along and make a better offer. Worse yet, there may be no GE stock to buy!
As you know, investors are not required to list their buy or sell prices for the stock they own. If we relied solely on individuals, some stocks could not be bought at any price and some stocks could not be sold at any price. This is why every stock on a stock exchange has to have a market maker. By always being ready to buy or sell, the market maker ensures that when you get ready to dump your stock, you can sell immediately. Conversely, when you get ready to buy stock, you can quickly find stock to buy. As such, they “make” the market possible.
The difference between the buy (or “bid”) price and the sell (or “ask”) price is called the “spread.” A market maker earns money on account of the spread. Normally if an equal number of people want to buy and sell, the market maker makes money on the spread (the difference between their bid and ask prices). Historically, a spread was one eighth of a dollar (twelve and a half cents), the smallest change that a stock could make. With the change in recent times to digital pricing spreads have become very small and additional companies compete as additional market makers.
With a market maker, if more people want to buy the stock than are willing to sell the stock, the market maker sells some of their holdings in order to create a market. Every time someone buys at the asking price the market maker can move the bid and ask prices up slightly. Gradually as the price moves up, less people want to buy the stock and the market maker ensures it won’t run out of stock.
Similarly, sometimes there are more people who want to sell a stock than buy it. Every time someone sells, the market maker must buy it. Once they do, they can also move the bid and ask prices down slightly. As the price the market maker is willing to pay for a stock goes down, fewer and fewer people are willing to sell at the lowered price. Thus, the market maker will not need to spend piles of cash buying up unwanted stock.
Market makers have to buy stock as long as people want to sell it. They also have to be able to sell stock as long as investors want to buy it. Their ability to move the price provides the negative feedback to allow them to make the market, no matter how many buyers and sellers there are.
By moving the price up as more people want to buy, they also ensure that they won’t run out of stock prematurely. As they move the price up, fewer and fewer people want to buy and more people are willing to sell. Similarly if they move the price low enough, it will induce people to buy the stock again.
In addition to making money off the spread, market makers often make money from a stock’s volatility. Stock prices can move wildly even with very little trading, if all the volume goes in one direction. If the only trading in GE stock is from investors buying the stock, all GE stock will likely rise in value, thus driving up the value of the GE shares the market maker holds in inventory.
Because market makers have to buy when no one else wants to and sell when everyone else is buying, they are the perfect contrarians. In other words, they buy when the stock is low and sell when the stock is high.
My grandfather was working on Wall Street during the 1929 crash and several years afterwards before losing his job. What is really amazing about the crash is that the markets worked. Because they were free markets they were able to successfully negotiate a tremendous price correction. Market makers provide a valuable service to investors by guaranteeing there will be a market for the stock you want to buy or sell.
Photo of Donald Mortlock owned by author.