Market makers or dealers are merchants who make money by buying low and selling high. They must set prices, market their services to acquire clients, manage their inventories, and they must be careful that they do not trade with better-informed traders.

Dealers in the financial markets supply liquidity to their clients who want to buy and sell trading instruments. They allow people to trade when they want to trade. They buy when their clients want to sell, and they sell when their clients want to buy. Dealers are called passive traders. They do not control the timing of their trades, so they must be very careful about how they offer to trade and to whom they offer to trade.

Dealers make money by buying at low prices and selling at high prices. They lose money when market conditions force them to sell at low prices or buy at high prices. These losses often occur after they trade with informed traders.

Dealer inventories

The positions that dealers have in the instruments they trade are their inventories. These positions may be long or short.

Target inventories are the positions that dealers want to hold. If short and long positions are equally costly to create and hold, the target inventories of dealers who do not also speculate, hedge, or invest are zero. Dealers who hold no inventory avoid the costs of financing their positions, and they do not lose when prices move against their positions. Dealers who speculate, hedge, or invest have target inventories that reflect these objectives. For example, the target inventories of dealers who also speculate are long when they think their instruments are undervalued or when they anticipate excess demand. If dealers allow their inventories to get too far out of balance, they will not have enough capital to finance their purchases or secure their short sales. At that point, whoever clears their trades will force them to liquidate.

When dealers want to decrease their inventories, they lower their bid and ask prices. Conversely, when dealers want to increase their inventories, they raise their bid and ask prices, increase their bid sizes, and decrease their ask sizes. Dealers who want to adjust their inventories quickly may not be willing to wait for another trader to come to them. Instead, they may initiate a trade with another trader who is offering to trade. This tactic quickly solves the inventory problem, but it is expensive since the realized spread will be negative.

Dealers must control their inventories in order to trade profitably. Large positions are expensive to finance. They also expose dealers to serious losses if prices move against them. This is called the inventory risk.

When dealers inventories are in balance, they want to buy and sell in equal quantities so that their inventories remain near their target levels. A two-sided order flow includes a mix of buyers and sellers who want to trade equal quantities. Dealers try to set their prices to obtain two-sided order flows.

Inventory risk

Diversifiable inventory risk

Diversifiable inventory risks are due to events that cause price changes no one can predict. On average, those price changes are zero. Otherwise, they would be predictable. Since the price changes are uncorrelated with their inventory balances, dealers gain and lose with equal probabilities.

Diversifiable risks are diversifiable because dealers can minimize their total inventory risk by dealing in many instruments. Unexpected gains in some instruments often offset unexpected losses in other instruments.

Adverse selection risk

Dealers face adverse selection risk when they with informed traders. Informed traders buy when they think that prices will rise and sell otherwise. If they are correct, they profit, and whoever is on the other side of their trades loses. When dealers trade with informed traders, their realized spreads are often small or negative. The best way dealers can avoid informed traders is to set their quotes near fundamental values so that informed traders will not want to trade.