Intro to Market Making
Nawfal Haji · 29 September 2026
A basic introduction to market makers, the reason they exist and the history of them.
What is Market Making?
Overview
At an airport, currency booths allow you to swap your local currency to another. They display two prices, one which they will buy at and one which they will sell at. The booth therefore buys your cash at a lower price and sells it to someone else at a higher price. In essence, this is what a market maker does!
The role of a market maker is to continuously quote prices, providing liquidity to the markets. They are willing to hold the resultant risk from facilitating transactions on their books, and in turn they profit by creating a bid-ask spread.
- Bid: The price a market maker is willing to buy at
- Ask: The price a market maker is willing to sell at
- Bid-Ask Spread: The difference between the bid and ask price.
Why Do Market Makers Exist?
Market makers provide liquidty to markets. When you buy a stock on your phone, that transaction happens instantly because market makers exist and are willing to facilitate it. Markets without a market maker, like buying a house, often take weeks to buy and then weeks to sell, because you would need to manually match a buyer with a seller. The market makers other function is price discovery; Market makers absorb lots of information in order to determine a common price for an asset.
How Do Market Makers Make Money?
Market makers are constantly profiting from spread capture, which is essentially buying low and selling high. When quoting prices, they quote a bid-ask price around their fair value, and wil therefore be constantly buying under fair value and selling above fair value, profiting off the bid-ask spread. Additionally, by being in the middle of the market, market makers have access to vast amount of information. This may lead to them making decisions on how they manage their inventory risk, or even take speculative positions when they find mispriced opportunites.
Example:
Suppose we were making a market on some company, and our market was 100@101. If someone comes along and wants to sell 50 shares to us, we would be long 50 shares at 100. Later on, someone wants to buy 50 shares from us, so we sell 50 to them at 101. In these two transactions, we have pocketed 50 for ourselves.
History of Market Making
Early Financial Markets
Modern market making can be traced back to 17th century Amsterdam, after the Dutch East India Company issued publicy traded shares in 1602. The amsterdam stock exchange became the worlds first dedicated stock exchange, which is why many market makers remain in Amsterdam to this day.
Floor Trading and Specialists
Before the birth of electronic markets, trading took place on physical floors at exchanges called pits, through open outcry. Brokers would move between trading posts and negotiate directly with market participants. Slowly, specialist market makers began providing liquidity to a set of securities, eventually evolving to become designated market makers, which still exist on the floors of some exchanges like the NYSE.
The Shift to Electronic Markets
In the late 20th century, computers began to take over some of these functions. With orders being transmitted electronically, prices could be updated automatically, and eventually algorithms began making markets instead of floor traders. Though OTC (over the counter) markets still exist today between humans, a large volume of equities and futures bought and sold are carried out by algorithms today!
Rise of Quantitative and High-Frequency Market Making
The rise of electronic market making gave birth to the modern day market maker: HFT and Quantitative market makers. Firms like Optiver, SIG and DRW while originating in the pits, led the charge in implementing statistical models, algos and software to dominate the human traders. Today, all market makers are at the cutting edge of technology and mathematics to try and gain an edge over eachother through speed or better models.
Avellaneda - Stoikov
For anyone interested in market making, I would recommend reading this paper and trying to implement the model yourself.
Avellaneda and Stoikov model market making as a stochastic control problem in an electronic limit order book. The key idea is that a market maker should not simply quote symmetrically around the mid-price: their quotes should depend on their current inventory, the risk of holding that inventory, and the probability that their orders will actually be filled.
I won't bore you with the maths here, but the intuition is simple. As a market maker, you generally do not want to accumulate an increasingly large position in one direction. If you are receiving lots of flow on one side and building up too much inventory, what can you do? You skew your quotes!
For example, if you are too long, you can make your ask more attractive while making your bid less attractive. This encourages other traders to buy from you and discourages them from selling even more inventory to you, naturally pushing your position back towards a level you are more comfortable holding.
The paper formalises this trade-off between earning the spread, attracting order flow, and managing inventory risk. For a more rigorous understanding of how the optimal quotes are derived, I highly recommend reading the original paper.
Conclusion
To conclude, market makers are essential to the financial markets and allow everyone, from regular people investing in an ISA to hedgefunds taking speculative positions to have quick, easy and transparent access to the markets. The modern day market maker looks very different from 100 years ago, and in another 100 years will probably look completely different again. In the mean time however, I would recommend reading the following for more information:
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