Trading and Exchanges Chapter 13: How Dealers Make Money in Markets
Dealers are merchants. They buy low, sell high, pocket the difference. If you ever bought a used phone from a resale shop, you understand the concept. The shop bought it for less, sells it to you for more. Financial market dealers do the same thing with stocks, bonds, and currencies.
What Dealers Actually Sell
The product is immediacy. You want to buy right now? The dealer is there. You want to sell right now? The dealer takes the other side. Without dealers, you wait until someone wanting to trade the opposite direction shows up. Could be minutes, hours, or never.
The price for this service is the bid-ask spread. The dealer buys at the bid and sells at the ask. If a dealer bids 35.0 and offers 35.3, that 0.3 spread is what they hope to earn per round trip.
Hope is the keyword. In reality, the realized spread is often smaller than the quoted spread. Harris gives an example where a dealer buys at 35.0 but bad news drops, so she has to lower her ask to 34.9 to unload. She loses 0.1 on the round trip. Quoted spread was 0.3, realized spread was negative.
Inventory Management Is Everything
Dealers do not want to hold positions. A dealer who just bought stock is not sitting there hoping the price goes up. They want to sell it as fast as possible and get back to zero.
They have a target inventory and constantly adjust prices to stay close to it. Own too much? Lower both bid and ask. Lower ask encourages buyers to take inventory off their hands. Lower bid discourages sellers from adding more. Inventory too low? Raise prices to attract sellers and push away buyers.
This is how price discovery works in practice. Dealers keep adjusting until buying and selling volumes match. When supply equals demand, they found the market value.
The worst scenario is getting stuck with a large position while prices move against you. That is inventory risk. Many dealers have gone bankrupt exactly this way.
The Informed Trader Problem
This is the chapter’s most important idea. Dealers face two types of inventory risk. One is random price moves nobody can predict. Annoying but manageable, because gains and losses average out over time.
The second type is adverse selection. This one is a killer.
Informed traders know something the dealer does not. They buy when prices are about to rise and sell when prices are about to drop. When an informed trader sells to a dealer, the dealer ends up holding something about to lose value. Order flow becomes one-sided. Inventory balloons, prices drop, dealer takes a loss.
This is why dealers are paranoid about counterparties. Large orders? Probably informed. Impatient traders needing execution right now? Might have time-sensitive information. Anonymous orders through brokers? Suspicious, because informed traders love anonymity.
Harris has a great example with Madoff’s firm (before the Ponzi scheme was discovered). Madoff only traded with retail clients, reasoning they are not well informed. The firm refused institutional clients unless they used “Time Slicing,” which broke large orders into small pieces over time. This filtered out informed traders needing fast execution and let Madoff offer better prices to everyone else.
How Dealers Protect Themselves
When a dealer suspects they traded with someone informed, the playbook kicks in. Bought from a suspected informed seller? Lower both bid and ask immediately. Lower bid stops more informed sellers from dumping. Lower ask encourages others to buy the inventory before prices fall further.
If really nervous, they skip waiting and actively dump the position at someone else’s bid, taking a loss on the spread just to get out.
Smart dealers also build adverse selection into their spreads ahead of time. They set ask prices based on “what is this worth if the next trader is an informed buyer” and bid prices based on “what is this worth if the next trader is an informed seller.” Those two estimates differ, so the spread widens. This is the adverse selection component of the spread, and a big reason why trading large orders is expensive.
Two Types of Dealers
Poorly informed dealers cannot distinguish informed from uninformed traders, so they treat everyone as dangerous. They keep positions tiny, flip inventory constantly, earn small spreads but compensate with volume. These are your scalpers and day traders.
Well-informed dealers understand fundamental values, can separate noise from signal, take bigger positions, hold them longer, earn larger spreads. They are basically value traders who also provide liquidity.
Fun detail: foreign exchange volumes (trillions per day) were historically insane partly because FX markets were opaque. Dealers traded with each other constantly just to learn what was happening. A position would pass through multiple dealers before finding a natural home. As markets became transparent, volumes actually decreased.
Bluffers and the Final Lesson
Dealers also worry about bluffers who fake order flow to manipulate prices. A clever trader wanting to sell big might first send a small buy order. Dealer sees buying pressure, raises prices. Then the clever trader anonymously sells at the inflated price. To avoid getting gamed, dealers must adjust prices at a consistent rate regardless of order direction.
The core lesson: dealing looks simple (buy low, sell high, pocket the spread) but reality is a constant battle against informed traders, inventory risk, and manipulation. The dealers who survive figure out who they are really trading with.