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A "market
maker" is a broker-dealer or bank that stands ready to
buy and sell a particular stock on a regular and continuous
basis at a publicly quoted price. A market makers first priority
is to establish and maintain liquidity for a given security.
Market makers generally must be ready to buy and sell at least
100 shares of a stock they make a market in. As a result,
a large order from an investor may have to be filled by a
number of market makers at potentially different prices. Each
market maker competes for customer order flow by displaying
buy and sell quotations for a guaranteed number of shares.
Once an order is received, the market maker immediately sells
from its own inventory or seeks an offsetting order.
For example,
a market maker has entered a sell order for ABC Company and
the bid/ask is $1.00/$1.06. The market maker tries to sell
shares of ABC at $1.06. If successful they then turn around
and enter a bid order to buy shares in ABC. The market maker
can bid higher or lower than the current bid of $1.00, if
this market maker enters a bid at $1.01 then a new market
is created because their bid price is now the best bid. If
the market maker attracts a seller at the new bid price of
$1.01 then they have successfully "made the spread."
The market maker sold 1000 shares at $1.06 and bought these
shares back at $1.01. As a result, the market maker made $50
(1000 shares x 5 cents) on the difference between the two
transactions. Doing this repeatedly with larger order sizes
can provide extremely high profits. Market makers do this
all day long to provide liquidity to individual and institutional
investors. The faster a market maker can make the spread the
more money they can potentially make.
Many OTC
stocks have more than one market maker. The more market makers
there are in a given stock, the more likely they are to bid
against each other, and the price will more likely be a true
"market" price. Be very cautious of stocks that
have one or only a few market makers as price manipulation
is more likely to occur. Price manipulation results, for example,
when one market maker buys a large chunk of stock and artificially
hypes the stock until there are no more buyers. The stock
then plummets as the market maker sells out and the investors
are left with no way out of their investment.
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