New on FinoLib · Volume III: Finance Encyclopedia
New on FinoLib, my finance education website: I have published an article called Bid-Ask Spread and Market Makers Explained, from Volume III: Finance Encyclopedia. Here is what the article explains, written as a short expert briefing; the full piece, with every worked example, is one click away.
5.3 Market Makers and the Bid-Ask Spread
The idea in plain words
Market makers earn the bid-ask spread by standing ready to buy and sell. The spread pays for three costs: processing orders, the risk of holding inventory, and adverse selection, which means losing money to traders who know more than the market maker does. Adverse selection is why spreads widen around news and in small, opaque companies, where informed traders have the biggest edge.
Key points
■In the Glosten–Milgrom model, a 20% informed share between values of $49.80 and $50.20 produces a $0.08 spread with no other costs.
■Kyle’s lambda measures price impact per share of net order flow; more noise trading makes markets deeper.
■Effective spread = realized spread + price impact; in the example, $0.03 of a $0.04 effective spread was price impact.
A closer look
A market maker continuously quotes both a bid and an ask price for a security, standing ready to buy or sell at those prices, providing the market’s ongoing liquidity — anyone wanting to trade immediately can transact against the market maker’s quotes rather than waiting for another genuine buyer or seller to appear. The market maker’s compensation for providing this constant willingness to trade is the bid-ask spread itself: buying at the (lower) bid and selling at the (higher) ask, capturing the small difference on each completed round trip.
Decision rule
If a stock’s quoted spread widens while its volatility has not changed, read it as rising adverse selection, often ahead of earnings, deals or news, and avoid market orders until it narrows. If you post resting orders, track realized spread: if price impact keeps exceeding about half of the effective spread, your quotes are being picked off. These are rules of thumb; they fail just after scheduled announcements, when every spread widens at once.
The costliest mistake
Reading the effective spread as the market maker’s profit. In the example above, the effective spread was $0.04 a share but the realized spread was $0.01, because the midpoint moved $0.015 against the market maker within five minutes. A firm budgeting the full $0.04 on 1,000,000 shares a day would expect $40,000 of gross revenue and earn $10,000 before fees and systems costs.
5.4 Price-Time Priority and Matching Engines
The idea in plain words
Most trading is matched continuously by two rules: best price first, and among equal prices, whoever was first in line. Exchanges also run call auctions at the open and close, which match all orders at the single price that allows the most shares to trade. And they halt or pause trading when prices move too far, too fast, to give people time to think.
Key points
■In the worked auction, executable volume peaked at 1,000 shares at $50.00, and every trade printed at that price.
■US closing auctions handled about 9% of daily volume in 2024 and about 20% on rebalance days.
■US market-wide circuit breakers trigger at 7%, 13% and 20% falls in the S&P 500; single stocks have Limit Up-Limit Down bands and five-minute pauses.
A closer look
When multiple orders sit at the identical price in the order book, most exchanges use price-time priority to decide which order executes first: orders at a better price always execute before orders at a worse price, and among orders at the identical price, the order that arrived first in time is filled first. The exchange’s matching engine is the software system continuously applying this rule, processing incoming orders and executing matches, typically within microseconds — the exact infrastructure that high-frequency trading (5.6) is built to interact with as fast as physically possible.
Decision rule
If you must trade at the official close (index tracking, fund valuation, a closing benchmark), use market-on-close or limit-on-close orders in the closing auction rather than trading in the final minutes. If your order exceeds about 5% of expected auction volume, use a limit-on-close and watch the published imbalance. For small orders in liquid stocks the difference is a few basis points and can be ignored.
The costliest mistake
Assuming a generous auction limit cannot move the price. In the example, the buyer of 200 shares at $50.10 paid $50.00. Had the buyer sent 2,000 shares at $50.10, executable volume would have peaked at 1,500 shares at $50.10, so the auction would have cleared $0.10 higher, costing 1,500 × 0.10 = $150 more on this tiny book and proportionally more on a real one. Check the imbalance before sizing an auction order.
What the full article covers
In the full article I take you through these sections:
■5.3 Market Makers and the Bid-Ask Spread
■5.4 Price-Time Priority and Matching Engines
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
Read the full article on FinoLib
The complete article, Bid-Ask Spread and Market Makers Explained, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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