Dealers and Market Makers: Who Keeps Markets Running (Chapter 13)
Book: Trading and Exchanges: Market Microstructure for Practitioners Author: Larry Harris Publisher: Oxford University Press, 2003 ISBN: 0-19-514470-8
Previous: Bluffers and Manipulation
Think of a dealer like a used car lot owner. They buy cars from people who want to sell, they sell cars to people who want to buy, and they try to make money on the difference. Financial market dealers do the exact same thing, just with stocks, bonds, and contracts instead of Hondas.
Chapter 13 of Larry Harris’s book is all about these dealers. And honestly, it is one of the most important chapters for understanding how markets actually work.
What Dealers Actually Do
Dealers are merchants. They buy low and sell high. The product they sell is called immediacy. When you want to trade right now, a dealer is the person willing to take the other side of your trade.
Here is the thing. When a dealer buys something from you, they usually have no idea who they will sell it to or when. If the price drops before they can sell, they lose money. Same thing in reverse. This uncertainty makes dealing risky, stressful, and sometimes terrifying. Plenty of dealers have gone bankrupt because a big bet went wrong.
Dealers are passive traders. They do not pick the timing of their trades. Other people come to them. So dealers have to be extremely careful about who they trade with and at what prices they offer.
Bid, Ask, and the Spread
Dealers quote two prices. The bid is what they will pay to buy from you. The ask is what they will charge to sell to you. The difference between the two is the bid/ask spread.
The ask is always higher than the bid. That spread is how dealers make money. Buy at the bid, sell at the ask, pocket the difference. Simple in theory. Way harder in practice.
But the spread dealers actually earn, called the realized spread, is usually smaller than what they quote. Why? Because dealers constantly adjust their prices between trades. Bad news hits, they lower their quotes. Good news, they raise them. By the time they complete a round trip (buy then sell, or sell then buy), the prices have shifted.
Dealers who quote both a bid and an ask are making a two-sided market. Most dealers will aggressively price only the side they actually want to trade on. If they need to buy inventory, they set a high bid to attract sellers and a high ask to discourage buyers.
Managing Inventory
Inventory management is everything for a dealer. Their inventory is whatever position they are holding in the instruments they trade. If they buy more than they sell, inventory goes up. Sell more than they buy, inventory goes down.
Dealers have a target inventory. When they drift away from that target, they need to get back. How? By adjusting prices.
Want to reduce inventory? Lower both bid and ask prices. The lower ask encourages people to buy from you. The lower bid discourages people from selling to you. Want to increase inventory? Do the opposite.
This constant price adjustment is the price discovery process. Dealers are searching for the price that balances supply and demand. At that price, roughly equal numbers of buyers and sellers show up.
The worst case for a dealer is getting stuck with a huge position. Large positions are expensive to finance and expose dealers to massive losses if prices move the wrong direction. Dealers who let their inventories get too far out of balance can literally go bankrupt.
The Informed Trader Problem
This is the big one. Dealers lose money when they trade with people who know more than they do. And that happens more often than you might think.
Say an informed trader knows a stock is about to drop. They sell to a dealer at the current price. The dealer happily buys, thinking everything is normal. Then the price drops. Now the dealer is holding something worth less than what they paid. That is adverse selection. The informed trader selected the side of the trade that was adverse to the dealer.
Informed traders make the order flow one-sided. When they are buying, the dealer keeps selling and their inventory drops. When they are selling, the dealer keeps buying and inventory piles up. If prices change before the dealer can rebalance, the dealer loses.
There are two types of inventory risk. Diversifiable risk comes from random price changes that nobody can predict. Sometimes you win, sometimes you lose. Over time it evens out. This risk is scary but not fatal.
Adverse selection risk is the dangerous one. It comes from informed traders. This risk does not even out. Dealers consistently lose when trading against people with better information.
How Dealers Fight Back
Dealers have several tactics for dealing with informed traders.
First, they try to set their bid and ask prices as close to fundamental value as possible. If prices are right, informed traders have no reason to trade with you.
Second, dealers watch the order flow obsessively. If they notice one-sided trading, they suspect an informed trader is at work and adjust their prices immediately.
Third, they try to avoid informed traders entirely. Some dealers refuse to trade with large institutional accounts because those accounts are more likely to be well informed. Others only accept retail order flow because retail traders are usually uninformed. The book mentions Bernard Madoff’s firm as an example of a dealer that specifically chose to serve retail clients to minimize adverse selection. (This was written before Madoff’s massive fraud was discovered, which adds an ironic layer.)
Fourth, dealers sometimes intentionally trade with known informed traders just to learn information. They take a small loss on the trade but gain valuable insight about which direction values are moving.
Well-Informed vs. Poorly Informed Dealers
Not all dealers are equal. Poorly informed dealers do not know fundamental values very well, so they cannot tell whether their clients are informed or not. They tend to trade quickly, keeping positions small, flipping inventory fast. They earn small realized spreads but can still be profitable if they turn their inventory rapidly.
Well-informed dealers understand fundamental values. They can better judge who is informed and who is not. They are more comfortable holding larger positions for longer. They earn larger realized spreads and can patiently wait for the right counterparty.
High-frequency dealing is sometimes described as “picking up pennies in front of a steamroller.” You make small profits over and over, but if you are not careful, one bad trade wipes everything out.
Dealers and Value Traders
Dealers who are extremely well informed about fundamental values start to look a lot like value traders. Value traders step in when prices diverge significantly from what they believe to be the true value. They provide depth to the market by being willing to take large positions.
When poorly informed dealers mistakenly overreact to normal order flow and move prices away from fundamental value, value traders show up and trade with them. The dealers get their inventory back in balance. The value traders wait for prices to correct. Both can profit.
Dealers and Bluffers
Dealers must also watch out for bluffers. Since dealers adjust their prices based on order flow, a clever bluffer can submit orders designed to manipulate the dealer’s prices. They might send a small buy order to push the dealer’s price up, then sell a large amount at the artificially high price through a different channel.
To protect themselves, dealers must adjust their prices at a consistent rate per quantity traded, regardless of whether orders come quickly or slowly, in large or small sizes, or from known or unknown traders.
The Bottom Line
Dealers are the liquidity backbone of financial markets. They make it possible for you to trade whenever you want. But they face serious risks doing it. The most dangerous risk is trading against someone who knows more than they do. Every decision a dealer makes, from where to set prices to who to trade with, is shaped by this reality.
Understanding how dealers think is essential whether you are a trader, an investor, or just someone trying to figure out why your stock’s bid/ask spread just widened.
This is part of a series on Larry Harris’s “Trading and Exchanges: Market Microstructure for Practitioners.” The book is dense and technical, but it explains the real mechanics behind how markets work. If you trade anything, it is worth your time.