Are you curious about market making and its fundamental terms? Look no further! In this post, we'll dive into the world of market making and introduce its key concepts and vocabulary.
What is market making?
Market making is a crucial function in financial markets where a participant, known as a market maker, provides liquidity by continuously quoting bid and ask prices for a particular asset. The market maker plays a vital role in facilitating smooth trading activities.
Let's explore some essential terms in market making:
- Bid and Ask Prices: These are the prices at which a market maker is willing to buy (bid) or sell (ask) a specific asset. The bid price is typically lower than the ask price, creating a spread.
- Spread: The spread represents the difference between the bid and ask prices. It serves as a measure of market liquidity and the compensation received by the market maker for providing liquidity.
- Liquidity: Liquidity refers to the ease with which an asset can be bought or sold without significantly impacting its price. Market makers contribute to liquidity by providing continuous bid and ask prices, narrowing the spread, and absorbing buy and sell orders.
- Order Book: The order book displays a list of outstanding buy and sell orders for a particular asset. Market makers closely monitor the order book to assess market conditions and adjust their quotes accordingly.
- Market Depth: Market depth refers to the volume of buy and sell orders at different price levels in the order book. It helps market makers gauge the overall liquidity and potential market impact of their trades.
- Market Maker's Profit: Market makers aim to profit from the bid-ask spread by buying at the bid price and selling at the ask price. However, they must carefully manage their inventory and exposure to market risks.
Now that you have a foundational understanding of market making and its key terms, you're ready to explore the fascinating roles of market makers and liquidity providers.