[TaylorPhebillo]

That seems true, but in practice it seems like a market maker can't offer competitive spreads without having a decent sense of market direction, and they will have to take a position for at least a little while before closing out. So the line between a market maker and a trader who takes deliberate positions feels pretty fuzzy.

[hattmall]

In options market makers get paid from price escalations, but some brokerages pass them on to traders. No one with any sense is placing market orders for options.

[seadan83]

Competitive spreads tend to be a function of volume (ie: liquidity). SPY options for example have very tight spreads while lesser traded options can have very large spreads.

Market makers balance positions by delta hedging and/or simply connecting trades. That means the direction of the market does not matter to them, market makers are not at all trying to make money off of market moves (they are making money by providing liquidity).

The 'connecting trades' example is common and easiest to understand. For example, one person is buying 100 shares, another is selling 100 shares. Both orders go to the same market maker and they are just connecting those two trades together. The time the market maker is actually holding shares is miniscule.

A slightly more complex example of the same kind of "connecting trades" is one person selling 1000 shares and ten other people buying 100 shares. Market makers will connect these trades as well, they'll buy the 1000 shares and then almost immediately (talking milliseconds) sell the 100 shares to the 10 buyers. They can turn around very quickly because the orders are queued. Sometimes trades will not execute right away even though it is well within a reasonable fill price, and that could be simply waiting for liquidity (eg: if someone is selling 10,000 shares, a market maker might do a partial fill if they can only found buyers for 1000 shares, in which case only 1000 shares are traded and the order would stay open for the remaining 9000 shares).

In this kind of 'trading' done by the market maker, there is almost zero risk, they are providing liquidity.

Though, not all trades can be connected together, which is a less desirable position for market makers in which case they create 'delta neutral' positions (positions that do not change in value despite any change in price of the underlying asset).

For example, let's say you are selling a call contract and there are no buyers. A market maker can still buy this contract from you without being exposed to delta risk. They would do this by buying the contract and then exercising it (creating a long position of 100 shares). At the same time, they open 100 shorts of the same underlying, creating a position with 100 long shares and 100 shorts, a net neutral position. Shares from exercising options are allocated by a clearing house after the trading day closes (5pm ET). This means when the market market actually gets the 100 long shares, that cancels out their 100 shorts and the position is closed. Meanwhile they were able to provide liquidity and allow someone to sell a call contract even though there were no buyers, and they were able to do so without any risk from moves in the market by creating a "delta" neutral position (any changes in price increase or decrease are offset between the long and equal short position).

Market makers do only make a best effort to provide liquidity. For example, if a market maker can't or won't open an offsetting short position, this is a place where there is no liquidity at all and you simply won't be able to execute your trade for any price (there is no market for that contract).

[TaylorPhebillo]

[Deleted a previous reply out of an abundance of caution about proprietary strategies]

That matches my first order academic understanding of market makers, but not the more detailed work I've read, or the work of the QRs at the handful of market makers I've spoken to/worked with.

It didn't seem like connecting trades were a particular focus of the people I've spoken with- is that something that happens off exchange? My understanding is that would happen automatically on the exchange, and that primarily market makers connect trades across time, pocketing bid/ask spreads but accepting risk of adverse price movements while they hold that position. To mitigate that risk, they do a bunch of signal analysis to set the spreads low enough to be competitive, high enough to mitigate that risk. Some market makers famously pay and provide price improvement for small/uncorrelated orders from retail brokers. I was told that that was specifically because of the reduced risk of adverse market movement from retail orders.

Market makers are generally required to always provide buy and sell prices, or risk fines/losing their market maker status on an exchange, right? Those prices might be extremely unreasonable (e.g. in a flash crash setting sell prices to 9999999), but if there's a market maker, there is required to be a price at which they will execute a trade, whether or not they can hedge that risk or now.