I guess so. The problem is I really can't get my head around how market makers are supposed to work. If my stock performs well it should be easy to sell it for a fair price in case I need the money because somebody else will happily take the opportunity to make some money. If the stock does not perform well I will feel more comfortable with a market maker offering to buy the stock but what is the incentive of the market maker to buy my stocks? Almost the same goes for the other way - why should a market maker sell a well performing stock to me? If on the other hand the stock does not perform well but I really want some I should be able to get some anyway because others will be happy to get rid of them. I am always tempted to call bullshit on stock market liquidity but then the term is all over the place and I am pretty sure that not everybody besides me is an idiot and so I guess I am just missing an important point.
Market makers are licensed by and incentivized by the exchange. They will usually have cheaper or no transaction costs, be given order priority over other market participants, have more relaxed rules on quote display times, or any other combination of advantages over all other market participants. In return they are required to take both sides of the market (eg: buy when everyone else is selling) and respond to a minimum percentage of quotes (eg: trade when no one else wants to). For the exchange the advantage is that they provide a minimum level of liquidity at all times which is what attracts traders to the exchange.
They will usually have cheaper or no transaction costs, or, in some cases, a negative transaction cost--paid by the share traded by the exchange to ensure liquidity.
I wrote this a few months ago, trying to explain market makers; I lightly edited it to make it make sense on this thread.
At any given point in time, the "true" (buy-side) investors are likely to be relatively far apart on prices. This is especially true in thinly-traded markets. For example: consider housing, which is the canonical example of an illiquid market.
I know the value of my house (it's around $300k). Say I want to sell it. The more liquidity I need, the worse price I'm going to get. Anyone with any intuition for the housing market knows that if I have to sell my house tomorrow, I am going to get a god-awful price for it; the "tomorrow" price for my house is many tens of thousands of dollars off its true value.
This creates huge problems for homeowners. The obvious standard advice for sellers is to wait patiently for the best price, counting on many weeks or months before a reasonable offer arrives. But I have to pay money every month I hold on to the house. If I need to move immediately, for instance for a job, or because my financial circumstances have changed, I might need the house to sell quickly, and because houses are illiquid I have to accept a crappy price. Or consider trends in the market: by forcing me to hold the house for months rather than days, I'm maximally exposed to swings in the market. So if Chicago housing prices crater while I'm trying to sell, the extra time it takes to unload the house takes that price swing out of my hide.
(You can easily see how the same thing happens in reverse in "hot" markets like Palo Alto, with the buyer now assuming the role of the hapless Chicago seller).
The exact same thing happens in the public markets; it's just not as intuitively obvious because we're working in smaller deltas of time and price.
But the public markets have a huge advantage that the real estate market doesn't: market makers.
Imagine if houses traded (were bought and sold) so frequently that a smart company could make good educated guesses about the current value of any given house. Imagine if that company would on any given day snap up a house offered for sale. That company wouldn't pay my asking price for my Chicago house, but it would pay something much closer to it than the "true" market would. After buying my house, the company would immediately offer my house for sale at any price greater than what it bought the house for. I wouldn't care, though: either I'd be thrilled for the opportunity to sell my house quickly and painlessly, or I just wouldn't accept their offer and instead do what I do now, which is to wait for the best offer.
Assuming the housing market makers were smart, the money they'd get by forcing me to accept a lower bid would be "free money" they get simply by being smart about valuing houses and having capital available to deploy. We'd all be a little irritated at them for scalping distressed buyers and sellers. But something else will inevitably happen: other smart firms will smell the free money, and they will compete for it. To capture a share of the premiums, all they have to do is offer a slightly more favorable price, so that's what they'll do. Over time, the money the housing market makers will get less and less "free", and the price penalty for immediate liquidity will get lower and lower.
In my fantasy real estate market, I now have the opportunity to avail myself of a reasonable "market" order, or to buy or sell on a "limit" price. I could do that if there were housing market makers, but in their absence I can't, because the price hit for selling tomorrow is too great; it might be a 25% discount on my asking price, or even something close to 50%. That's the cost of illiquidity, or, stated more directly, the value of liquidity.
It's probably also worth saying that liquidity is a presumption of the public electronic markets. Because it's taken for granted, there are whole trading strategies (hedging, for instance) that depend on its presence. These trading strategies face execution risk: if they can't bail out of a position within a specific window of time, they incur losses for the trader.
Thanks, that helped. My major mistake was to assume bid and ask prices will not change and ignored that you might really need the money and are willing to reduce the asked price. So in essence market makers a paid to hold stocks they don't really want and take the risk of unfavorable price movements.
