Market making and order flow
Every time you buy at the ask, someone sold to you. Most of the time that someone is a market maker: a firm paid to stand ready to buy or sell at any moment.
How market makers make money
A market maker quotes both a bid and an ask, say 99.99 and 100.01. If it buys from one customer at 99.99 and sells to another at 100.01, it earns the 2-cent spread. Across millions of trades a day, small spreads add up. Exchanges often pay rebates for providing liquidity too.
The two risks
- Inventory risk: after buying from a seller, the market maker holds shares it didn't want. If the price drops before it can sell, it loses. It manages this by skewing quotes (lowering prices to encourage buyers) and by hedging.
- Adverse selection: some traders know more. If an informed fund is buying aggressively, the market maker keeps selling to them as the price rises against it. Spreads widen when informed flow is suspected, in thin markets, and around news.
Who they are
Modern market making is dominated by technology firms such as Citadel Securities, Virtu, Jane Street and Optiver. They use automated pricing, process huge order volumes and hedge across related instruments in milliseconds. In options, market makers quote thousands of strikes and expiries and hedge the resulting delta in the underlying, which is the hedging flow behind lessons 3.4 and 3.5.
Order flow
Order flow is the stream of buy and sell orders hitting the market. Traders study it because it shows intent in real time:
- Aggressive vs passive: market orders that cross the spread show urgency. Limit orders resting in the book show patience.
- Delta (buy minus sell volume): tracks whether buyers or sellers are more aggressive.
- Absorption: heavy selling into a level without price falling suggests a large buyer is soaking it up.
- Book depth: where liquidity sits, though resting orders can be pulled at any moment (and spoofing, placing orders you intend to cancel, is illegal).
Payment for order flow
In the US, wholesale market makers pay retail brokers to route customer orders to them, because retail flow is less likely to be informed. It enables commission-free trading but raises conflict-of-interest questions. It isn't permitted in the UK.
Key takeaway
Market makers provide liquidity in exchange for the spread, and they price in the risk that you know something they don't. Understanding their incentives explains why spreads widen exactly when you most want to trade.
Educational content only, not financial advice. Options involve significant risk and are not suitable for everyone.