Gary Karz, CFA 
Host of InvestorHome
Principal, Proficient Investment Management, LLC
Online brokers and many investors are quick to point out that trades can now be made for commissions of $8 or less. This makes it easy to lose sight of the fact that commissions are not the only cost of buying and selling stocks. Investors are we'll served in becoming educated on the other cost of trading - the bid/ask spread.
Stock markets are not non-profit organizations staffed by social workers paid by the government to provide a public service. Brokers, specialists, and market makers don’t participate in the markets for their health. They trade only when they expect to make profits. Those profits are the price that investors and other traders pay in order to execute their orders when they want to trade.
The most common price for referencing stocks is the last trade price, but the last price is not necessarily the price that a person can subsequently trade now or in the future. At any given moment during market hours there is a best or highest "bid" price from someone that wants to buy the stock and there is a best or lowest "ask" price from someone that wants to sell the stock. Additionally, that bid and ask will be for a specific number of shares.
In every transaction one party is a price setter and the other party is a price taker. The price taker agrees to the price set by the price setter. In financial markets, a person who places a market order is effectively a price taker (a market sell order will be filled at the prevailing best bid price and a market buy order will be filled at the best ask price). A person who places a limit order is a price setter while a person who places a market order crosses the spread and effectively incurs a cost of half the spread. The person who placed the limit order captures that half spread. The risk for the person who places a limit order is that the order never gets filled because the price is never met.
Let take an example of Stock XYZ, which is currently quoted at 100 by 100.25. In other words someone is willing to buy XYZ at 100 and someone is willing to sell XYZ at 100.25. An investor that places an order to buy 100 shares of XYZ at the market will get executed at 100.25 while an investor the places an order to sell 100 shares of XYZ will get executed at 100. If the market maker placed both the bid and the ask and executed both orders he will earn the 0.25% as a profit. The market maker profits by doing this over and over again throughout market hours. The market maker loses money when he/she fills an order and reverses the trade at a worse price.
The following is an example of how a market maker can lose money. An institutional investor places a market order to buy 100,000 shares of XYZ. The specialist agrees to sell the shares at a price of 101. The market maker is now short 100,000 shares of XYZ and will make a profit if he can buy back the 100,000 shares for less than 101. However after completing the order, the same buyer places an order to buy another 200,000 shares. The market maker now has an outstanding order to buy shares yet his interest is also to buy shares back at a lower price. The term getting "bagged" is used by some to describe the market maker’s situation. In other words, a trader or market maker completes a trade only to have the opposing party push the price further by transacting even more shares in the market.
When transacting large orders, the market maker operates under the hope that the opposing party is finished transacting in that stock or that he has charged enough of a price concession to make up for any subsequent price impact from additional trades. But if the completed order is only part of a larger decision to buy more shares, the market maker can lose money as the additional buying pressure causes the stock to rise further.
Returning to the original XYZ example, let’s take an example of a person who places a buy order for 100 shares at 100.12. This person is attempting to save half the spread cost by placing a limit order. If the price rises and the order is never filled the investor will either have to live without the stock or pay a higher price. If the stock subsequently goes to 101, a person who placed a market order and paid 100.25 is clearly better off than the person who originally placed a limit order hoping to save .25, but never purchased the stock because it moved higher. Of course, we would all make the correct choice if we knew in advance what was going to happen. Therefore, the motivation for the trade must be considered when deciding whether to place a market order or a limit order. If the order is not time sensitive a limit order may end up costing less, but a market order may be the only way to get an order filled if the order is time sensitive and the price moves against you.
Institutional investors face the challenge of completing massive orders (often millions of shares) at a minimum cost. An institutional investor that exposes an order for a large number of shares can expect the price to jump immediately, so they may instead attempt to gradually work the order in small pieces over several days or weeks. Day traders will frequently try to buy or sell in advance of large working institutional orders if they can identify a large order in progress.
Institutional investors try to reduce their costs by trading with institutional brokers that specialize in handling large block orders and by using trading systems designed match to orders with other institutional traders. These systems attempt to eliminate the spread and any price impact. The first so-called Dark pool was ITG’s POSIT, but now there are many including Goldman Sachs's Sigma X, Credit Suisse's CrossFinder, Knightlink, Pipeline, and Liquidnet. Rosenblatt Securities, Advanced Trading and Traders Magazine are good sources of information on the dark pools. While trades completed through these system tend to have lower up front costs, traders run the risk of simply not getting their orders executed quickly or at all. Institutional investors incur opportunity costs as a result of not completing large orders and these costs can be a significant factor in performance. For more on opportunity costs see InvestorHome's trading costs page.
The purpose of a market is to provide a location where buyers and sellers can transact. The more buyers and sellers at any given time, the more efficient a market will be in matching buyers and sellers with minimum effort and costs. Electronic Communications Networks (ECNs) like Instinet work well when many market participants use the system simultaneously.
The NYSE and AMEX historically were specialist markets. A specialist was assigned to each stock and the specialist maintains a book of current bids and asks. In specialist markets, a market maker is expected to provide liquidity (by using their own capital) for large orders when buy and sell orders do not balance. The market maker takes the risk that prices will move against his position but also has the advantage of seeing the limit orders.
On NASDAQ there is no specialist so large orders can result in large price moves. NASDAQ uses a network of dealers connected electronically. Dealers place bid and ask prices on a continuous basis and trades are linked and executed electronically. Day traders historically tended to concentrate on NASDAQ stocks because orders and executions can be placed and confirmed with virtually no time delays. Orders placed on the NYSE historically could take longer.
The recent "flash crash" may have been caused by the buy limit orders being exhausted and as a result, market sell orders had little or no ask price to match with. Professor Larry Harris suggests a solution in
How to Prevent Another Trading Panic in the WSJ (5/12/2010).
Generally, the more liquid the stock the smaller the spread. Penny stocks and options have notoriously large spreads. If a security has a spread of several percentage points, an investor or trader attempting to make money would have to get several percentage points of price movement just to break even on a trade using market orders. Day traders tend to trade in very liquid stocks that have very small spreads.
With the rapid growth of ETFs, investors and traders should become familiar with the spread costs associated with trading specific ETFs. That is the subject of When 'Cheap' ETFs Aren't Really Cheap in Smart Money (April 2010), which notes that comparable ETFs should be evaluated not just for size, but for trading liquidity.
A difference between a professional market maker and a day trader might be that a day trader will generally open a trade and immediately try to reverse the trade while a market maker will not immediately try to reverse each trade. Over the course of the day the market maker will try to balance his book, but he will generally have more capital available and is more concerned with the average of many trades than concentrating on each individual trade during the day.
A distinction to be made with professional market makers and day traders is when they cross the line from market making activities to taking positions in order to speculate on the direction of securities. Some day traders are truly speculators trying to outsmart the market by buying in advance of market rises and selling in advance of market declines. This however is a zero sum game where someone wins a dollar for every dollar lost by someone else. See The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity by Larry Harris for more on this topic.
We know that market making is a profitable business because public securities firms regularly report profits from their securities trading departments and NYSE specialist firms are very profitable. See Investment Costs for links to research on that topic. Whether or not day traders make money is a separate question that has yet to be fully determined. See Do day traders make money? Of course we know that day trading brokerage firms make money by charging their customers commissions and it’s certainly in their interest to encourage more trading. See also
Ken French's paper titled The Cost of Active investing in the Journal of Finance (August 2008).
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