How Market Makers Set Bid-Ask Spreads?

Within the realm of stock trading, the bid-ask spread is a fundamental component that individual investors often overlook. This apparently little element may have a big influence on the price and way transactions are done. The spread is the variation between the price another market member is ready to sell (ask) and the price at which a market player is prepared to purchase or bid. Knowing how bid-ask spreads are formed by market makers would help traders better grasp the liquidity, volatility, and pricing policies of any given securities.

With an eye on the part market makers play in determining the bid-ask spread, this article will explore the elements influencing this spread and how they may impact trading techniques. Knowing the nuances of bid-ask spreads is very essential for traders in areas like the Philippines, where the stock market is expanding quickly, to make wise investment selections.

What is the bid-ask spread in stock trading?

The fundamental idea in financial markets, especially in stock trading, is the bid-ask spread, which shows the variation in the price a buyer (bid) is ready to pay for security against the price a seller (ask) is requesting for the same security. Depending on the price of the stock, the spread is often stated as cents or percent. The spread is usually limited because there is a constant flow of buyers and sellers for highly liquid equities such as blue-chip firms. On illiquid stocks—that is, those of startups or smaller businesses—the margin may be much more large.

One of the key markers of market liquidity is the extent of the spread. High liquidity, shown by a limited spread, makes buying and selling the stock simple. On the other side, a broad implies less liquidity, which means that there could not be enough buyers or sellers in the market to swiftly carry out deals at good value. The bid-ask spread affects the cost of joining or leaving a position, so traders should take it into account.

How do market makers determine the bid and ask prices?

Market makers are crucial in financial markets, including the Philippine Stock Exchange. Buyers and sellers act as middlemen to guarantee seamless transaction execution. Market players assess several elements to decide the bid and ask prices. The present supply and demand for a particular stock is one of the primary determinants. Should buyers outnumber sellers, market makers may increase the asking price. On the other hand, if there are more vendors than buyers, the bid price might be lowered to draw in business.

Trade volume is still another important consideration. Because they are traded often and let market makers take on less risk, high-volume equities usually have limited bid-ask spreads. Market makers often extend the spread for low-volume equities to offset the increased risk of hanging onto a stock that might not be readily traded.

Market makers also utilize advanced algorithms to instantly modify the bid and ask pricing. These systems consider macroeconomic data, market mood, and even news events that could affect the price of the stock.

What factors cause bid-ask spreads to widen or narrow?

Bid-ask spreads could broaden or reduce depending on many variables. First of all, liquidity is really important. High-liquidity stocks—such as those of Jollibee Foods Corporation or SM Investments—usually have limited spreads. On the other hand, because of their lack of regular trading, equities with lesser liquidity—that of small-cap or developing companies—have broader spreads.

A big part also is market volatility. Spreads often expand in times of great market uncertainty, like that of an economic crisis or major geopolitical catastrophe. Market makers adjust the spread to offset their expected higher risk. Conversely, spreads are usually limited under steady market circumstances as maintaining a position reduces the associated risks.

Finally, the distribution could be affected by market hours. Liquidity is often lower during off-peak or pre-market and after-market periods, which widens spreads. Spreads often shrink when the number of active players rises during normal trading hours when market activity is strong.

How do market makers profit from the bid-ask spread?

Bid-ask spread is one of the main methods by which market makers generate a profit. After purchasing them from sellers at the bid price, they sell equities to consumers at the ask price. The market maker's profit is shown in the difference between these two rates. Although the return from every transaction may be small for highly liquid companies, the number of trades offsets this.

In illiquid markets, however, market players may expand the gap in order to protect themselves from possible losses. The market maker has more possible profit margin the bigger the spread is. Market makers are paid for the risk they incur in holding onto assets that may not be readily traded, as well.

Moreover, market makers may use high-frequency trading techniques to profit from minute price swings. In one day, they may make hundreds of deals with little reward on each one. These little gains compound to become really large over time.

Why do less liquid stocks have higher bid-ask spreads?

Usually, for numerous reasons, less liquid equities are connected to larger bid-ask spreads. First of all, these equities are not traded as much as their more liquid equivalents, so market makers running them run greater risk. Market makers widen the spread to help reduce this risk and guarantee they are paid for the possible difficulties in locating a buyer or seller.

Fewer liquid equities also have less information, which makes it more difficult for market players to fairly evaluate their worth. Wider spreads result from this uncertainty as market makers must protect themselves against possible significant price fluctuations. Wider spreads on these kinds of assets would be seen by investors in the Philippines trading smaller equities or those in developing economies.

How does volatility affect the bid-ask spread?

One of the most important determinants of bid-ask spreads is market volatility. Spreads often expand during times of great volatility as market makers prepare for the likelihood of quick and erratic pricing swings. Volatile markets make it more difficult for market makers to ascertain the “true” worth of a company as prices may vary significantly within short times. They widen to control this ambiguity.

On the other hand, spreads are close-knit when market conditions are steady, and price swings are more consistent. Under these circumstances, market makers lower the spread as they are more sure of their capacity to control the risk of retaining securities. Understanding how volatility affects the spread is essential for traders in erratic markets—for example, during a financial crisis or significant political event—to maximize their trading plans.

Can retail traders affect the bid-ask spread?

Although institutional investors have more control over the bid-ask spread than individual traders, their combined activities nevertheless have an effect. Large buy or sell orders from private investors may change the supply-demand dynamics in markets where liquidity is limited or where there are few active players, influencing the market makers' spread. For instance, the increased demand can lead the asking price to climb if a group of individual investors starts buying a somewhat illiquid stock, therefore momentarily widening the gap.

Retail traders' impact on the spread is usually negligible in highly liquid markets as the great number of transactions from institutional investors and market makers overshadows individual trades. However, retail traders may sometimes influence the spread, especially when trading volumes surge, in smaller markets or with low-cap companies.

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