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Investor Mistakes About Market Makers

Few topics in finance are more widely misunderstood by retail investors than the role and behavior of market makers. Misconceptions range from benign (market makers are neutral service providers) to costly (market makers' quoted prices are guaranteed), and these errors compound across thousands of trades into substantial portfolio drag. This chapter catalogs the most common mistakes retail investors make about market makers and explains how clearer understanding of market structure improves trading decisions and outcomes.

Quick definition​

Common investor mistakes about market makers are systematic misconceptions that lead to poor trading decisions, including beliefs that: market makers are neutral intermediaries; quoted spreads are guaranteed; all brokers execute equally; liquidity is permanent; and market makers cannot profit from order flow information.

Key takeaways​

  • Market makers are profit-maximizing firms, not neutral intermediaries: They profit from spreads, information advantages, and order flow. Their interests don't necessarily align with yours.
  • Quoted spreads vanish during stress: The bid-ask spread you see on your app assumes liquid market conditions. During volatility, spreads widen dramatically or disappear entirely.
  • Broker choice matters significantly: Your broker's order routing decisions affect your execution quality. PFOF brokers may route to lower-paying market makers.
  • Market makers exploit information advantages: They access order flow data you don't have and structure quotes accordingly. This isn't illegal but creates a systematic disadvantage for uninformed traders.
  • Momentum strategies can trigger market-maker withdrawal: If you're trading in the same direction as broad market momentum, you may be competing for liquidity that disappears precisely when you need it.
  • Spreads are broader than they appear: The quoted spread (bid-ask) is only part of transaction costs. Order placement, impact costs, and adverse selection add to true execution costs.
  • Sophisticated retail traders can't consistently beat market makers: Market makers employ thousands of PhDs in mathematics, physics, and computer science. Retail investors competing against this intelligence face structural disadvantages.

Investor Mistakes and Their Costs​

Mistake 1: Assuming Your Broker Is Neutral​

Many retail investors believe brokers are neutral intermediaries that simply execute orders at the best available prices. In reality, brokers are businesses with financial incentives that may not align with your execution quality.

Under the payment-for-order-flow model, brokers are paid by market makers for order flow. Citadel Securities, Virtu, and other major market makers pay brokers like Robinhood, E*TRADE, and others roughly $0.001-$0.005 per share sold to them. This creates an economic incentive: brokers are incentivized to route orders to market makers who pay the most, not necessarily those offering the best prices.

A concrete example illustrates the impact:

  • Your broker receives $0.003 per share from Market Maker A for routing orders, even though Market Maker A quotes wider spreads.
  • Your broker receives $0.001 per share from Market Maker B, who quotes tighter spreads.
  • Your broker routes your orders to Market Maker A because they pay more, costing you money on execution.

Empirical research confirms this happens. Studies of retail order execution show that PFOF brokers' customers receive execution prices 1-3 cents per share worse on average than brokers that don't participate in PFOF or that route to better-priced market makers.

The implication: Don't assume your broker is neutral. Research their execution quality metrics (many brokers publish these) and compare. Some brokers (Fidelity, Vanguard) have reduced or eliminated PFOF participation. Others (Robinhood, Webull) depend on it entirely.

Mistake 2: Believing Quoted Spreads Are Guaranteed​

You open your brokerage app and see a stock quoted at $50.00 bid / $50.05 ask. You assume you can sell at $50.00 or buy at $50.05. This is true in normal markets. During stress, it's often false.

Quoted spreads are conditional on market conditions. When volatility is low, order flow is steady, and inventory is balanced, market makers quote tight spreads. When volatility spikes, order flow becomes one-sided (everyone selling or everyone buying), and inventory becomes unbalanced, market makers widen spreads or withdraw entirely.

A vivid example is the 2020 Zoom Video Communications (ZM) trading:

  • Before earnings, ZM was quoted $600 / $600.10 (very tight spread).
  • The day after earnings, ZM dropped 18% in minutes. The spread widened to $500 / $510 (2% spread, 20x wider than normal).
  • Some sell orders couldn't be executed, and others executed at $495 or lower—far from the quoted spread.

A retail investor who assumed the pre-earnings spread would persist through earnings would be shocked. Market makers had withdrawn and wouldn't quote actively in either direction.

This is particularly true for less-liquid stocks. A stock with normal spreads of $0.05 might have spreads widen to $0.50 or more during a market-wide volatility spike.

The implication: Don't assume quoted spreads persist. Be particularly cautious around earnings, during market-wide volatility spikes, and in less-liquid securities. If you need to trade a less-liquid position, use limit orders rather than market orders to control your execution price.

Mistake 3: Underestimating True Transaction Costs​

Retail investors often think their only transaction cost is the bid-ask spread. In reality, several other costs exist:

  1. The quoted spread itself: On a $100 stock with a 1-cent spread, you pay 0.01% to immediately execute. This seems trivial but compounds.

  2. Order placement costs: If you use a limit order that doesn't immediately execute, you may face an adverse price move while waiting. If you use a market order, you pay the spread plus any slippage between quote and execution.

  3. Impact costs: If you're trading a large size, you may move prices against yourself. You push up the ask price when buying or push down the bid price when selling.

  4. Adverse selection losses: If market makers know you're likely to provide stale information or make losing trades, they widen spreads against you. Retail traders are classified as "uninformed" by market makers, so they face wider spreads than institutions.

Consider a concrete example: you decide to buy $10,000 of a stock at $100/share (100 shares). The transaction costs might be:

  • Quoted spread: 1 cent per share on 100 shares = $1.00
  • Order placement: If you use a limit order, you might miss a 2-cent favorable move while waiting, costing $2.00
  • Broker PFOF disadvantage: Execution 2 cents worse than the best market maker would give: $2.00
  • Market impact: Your 100-share order pushes the ask up by 1 cent: $1.00
  • Total: ~$6.00 on a $10,000 trade = 0.06%

This still seems small. But for an active trader executing 100 trades per year, this compounds to 6% annually in just transaction costs. For a passive buy-and-hold investor, $6 on a $10,000 trade is negligible.

The implication: Be aware that true transaction costs extend beyond the quoted spread. These costs are unavoidable but can be minimized by: (1) trading highly liquid securities, (2) using limit orders to avoid slippage, (3) choosing brokers with better execution quality, and (4) trading less frequently.

Mistake 4: Thinking All Brokers Offer the Same Execution Quality​

Brokers differ substantially in execution quality for the same orders. These differences stem from:

  1. Order routing choices: Where does your broker send your order? To market makers paying the most (PFOF) or to venues offering the best prices?

  2. Rebate structures: Some brokers receive rebates from exchanges for sending order flow; others don't. These rebates affect their incentives.

  3. Relationships with market makers: Brokers with closer relationships to market makers or higher volumes might negotiate better prices than others.

  4. Technology: Some brokers have more sophisticated order routing algorithms that optimize across venues.

Academic studies have measured these differences. Researchers at Cornell and other institutions have found that execution quality varies by 2-5 basis points (0.02-0.05%) across brokers for the same orders. On a $100,000 portfolio, this amounts to $200-500 annually in execution quality differences.

The worst brokers aren't always the cheapest. Robinhood offers commission-free trading and appeals to retail investors but relies entirely on PFOF, resulting in worse execution than brokers like Fidelity or Vanguard that don't prioritize PFOF revenue.

The implication: Research your broker's execution quality metrics. Many brokers publish quarterly execution quality reports (required by the SEC). Compare execution prices across brokers for the same securities. If you're an active trader, the difference in execution quality might justify switching brokers.

Mistake 5: Not Understanding Adverse Selection and Information Asymmetry​

Market makers face a fundamental challenge: distinguishing informed traders (those trading on superior information) from uninformed traders (those trading for exogenous reasons like rebalancing or withdrawals).

If a market maker quotes a spread of $100.00 / $100.05 and you immediately buy at $100.05, the market maker might worry: "If this trader knows something I don't, the stock will rise and I'll lose money." In response, the market maker widens spreads against you.

Retail traders are classified as uninformed by market makers and institutions. This is because:

  1. Retail traders execute at worse times: They trade at market opens, around earnings, and in response to media stories—exactly when prices are most volatile and information is most uncertain.

  2. Retail traders lack data: They don't have access to institutional order flow data, insider information, or proprietary research.

  3. Retail trades are often mechanistic: They're driven by algorithmic rebalancing or behavioral responses to price changes rather than information advantage.

Because of this classification, retail traders face wider spreads than institutions with the same order size and type. If a large institution places a 10,000-share order, they might get a 0.5-cent spread. A retail trader placing a 10,000-share order gets a 2-cent spread.

This seems unfair but is an unavoidable consequence of information asymmetry. Market makers have learned through thousands of past interactions that institutional traders' trades are, on average, more informed than retail traders', so they price accordingly.

The implication: Recognize that your classification as an uninformed trader means you'll face wider spreads than you might prefer. You can mitigate this by: (1) trading very liquid securities where information advantage is smaller, (2) using limit orders to signal less urgency, and (3) trading at times when market makers have less adverse selection risk (avoiding earnings, market opens, and times of high news flow).

Mistake 6: Believing Market Liquidity Is Permanent​

Retail investors often observe that major stocks have tight spreads and assume liquidity is permanent. They plan trades around the assumption that they can instantly execute at the quoted spread anytime, anywhere.

This assumption breaks during crises. The March 2020 COVID-19 crash revealed how fragile this assumption is. Stocks like Tesla, Apple, and Amazon—among the most liquid stocks—experienced spreads that widened to 10+ cents, execution failures, and extended periods where orders couldn't be executed at quoted prices.

The cause was market-maker withdrawal. As volatility spiked and market makers faced enormous losses, they stopped quoting and withdrew from markets. Liquidity that appeared permanent evaporated.

This happens predictably during crises. The 2010 Flash Crash, the 2016 pound sterling flash crash, the 2018 Volmageddon options market crisis—all featured liquidity evaporation exactly when investors needed it most.

For retail investors in less-liquid stocks, this risk is even higher. A stock with a normal spread of 5 cents and decent depth might have spreads widen to 50+ cents during volatility, with very few shares available at any price.

The implication: Don't assume liquidity is permanent. Plan for worst-case scenarios where you might not be able to exit positions at quoted prices. For essential portfolio positions (ones you don't want to get stuck holding), trade liquid securities or maintain smaller positions in illiquid securities. During market stress, be prepared for dramatically worse execution.

Mistake 7: Overlooking That Market Makers' Profits Come From You​

This is perhaps the most fundamental misunderstanding. Many retail investors view market makers as service providers—like gas stations or restaurants—that facilitate transactions in exchange for a service fee (the spread). The implicit view is: "The spread is the cost of the service; market makers aren't earning profits beyond this cost."

In reality, market makers earn substantial profits that come directly from retail traders' wallets:

  1. Spread profits: A market maker buying at $100.00 and selling at $100.05 earns $0.05 per share. For a market maker executing 1 million shares daily, this is $50,000 daily or $12+ million annually in pure spread revenue.

  2. Information advantage profits: Market makers who trade ahead of anticipated order flow or anticipate price movements profit from information advantages that retail traders lack.

  3. Payment-for-order-flow profits: Market makers pay brokers to access retail order flow because they profit from trading against it. If they didn't profit, they wouldn't pay.

  4. Inventory timing profits: When market makers hold inventory, they hope to sell it at higher prices. When retail investors are net sellers, market makers are buyers and eventually sell higher (on average). This represents a wealth transfer from retail sellers to market makers.

Understanding this profit dynamic illuminates several realities:

  • Market makers aren't indifferent to whether you profit or lose. They actively structure quotes to profit from retail traders.
  • Wide spreads mean large market-maker profits per trade.
  • The reason brokers offer commission-free trading isn't charity; it's because they profit enormously from directing your trades to market makers.

The implication: Recognize that when you trade, you're trading against a sophisticated counterparty (the market maker) that profits when you lose or trade at worse prices. This isn't morally wrong—it's a legitimate business—but you should understand it's happening and structure your trading to minimize their profit from you.

Mistake 8: Assuming You Can Beat Market Makers Through Trading Skill​

Some retail investors believe that with sufficient skill, analysis, and effort, they can consistently profit at the expense of market makers and other traders. This belief is almost certainly wrong.

Why retail traders rarely beat market makers:

  1. Information disadvantage: Market makers access order flow and market microstructure data that retail traders don't. This creates a systematic advantage that's difficult to overcome.

  2. Technology disadvantage: Market makers employ thousands of engineers and scientists building advanced trading systems. A retail trader's personal trading system is unlikely to be competitive.

  3. Statistical disadvantage: Even with sophisticated analysis, the edge a retail trader might gain on individual trades is small. Statistical edge takes enormous sample sizes to manifest.

  4. Time disadvantage: Market makers trade constantly, refining their models and strategies. A part-time retail trader can't compete with this full-time effort.

  5. Capital disadvantage: Market makers can absorb losses and stay in the game longer. A retail trader with limited capital can be wiped out by a streak of bad luck.

Research on retail traders shows that the vast majority lose money. A famous study of day traders found that fewer than 1% earned a return exceeding what they could have earned from a passive index fund investment. Even disciplined, skilled traders struggle to beat the market in aggregate.

This doesn't mean no retail traders ever profit. A tiny percentage do, but they're selected for luck as much as skill. The problem is that individual retail traders can't distinguish their own skill from luck until decades of trading data exist—long after opportunity costs might have suggested alternative career paths.

The implication: If you aspire to profit from trading, be honest about whether you're pursuing a realistic goal or chasing a low-probability outcome. Most retail traders would be better served by passive indexing and focusing energy on earning and saving than by attempting to beat markets.

Mistake 9: Not Understanding Gamma Risk and Options Market Maker Dynamics​

Options market makers operate under different dynamics than equity market makers, and many retail options traders don't understand these differences.

In equity markets, market makers profit from spreads. In options markets, market makers profit from theta decay (time value erosion) while managing gamma risk (losses from volatility in the underlying stock).

A retail options trader buying a call option for $2.00 benefits if implied volatility rises or the stock rises. But market makers selling that option face losses if volatility rises (because they're short the option and long delta exposure to hedge). To protect against these losses, market makers quote options at prices that include a volatility premium—they quote higher prices than the Black-Scholes fair value would suggest.

This means retail options buyers systematically overpay for options, while retail options sellers undersell them. The advantage compounds across multiple trades and multiple options traders.

A typical retail options trader who buys calls and puts "plays" volatility discovers that their average outcomes are worse than they'd expect from just random chance. This is partly because of widened spreads (2-5% in options vs. 0.01% in equities) and partly because they're betting against market makers' sophisticated volatility models.

The implication: If you trade options, understand that you're competing against sophisticated volatility models and paying substantial transaction costs (in the form of option spreads). Most retail options traders would improve outcomes by trading less, using simpler strategies, and focusing on long-dated, simple positions (buying calls/puts) rather than complex strategies (spreads, straddles) where transaction costs overwhelm potential returns.

Mistake 10: Overlooking That Your Trade Information May Be Public​

When you place a trade, your order information is available to market makers and other traders in ways you may not realize.

Order flow visibility:

  • Direct information: Market makers can see your order flow directly if they're quoting on the same venue.
  • Indirect information: Market makers can infer your order flow from price and volume patterns.
  • PFOF information: Your broker provides order flow information to market makers they route to, including information about order direction, size, and timing.

Market makers use this information to adjust quotes. If they see a large buy order coming from your broker, they might widen the ask to profit more from that order. If they infer that you're a retail trader (likely based on order size, timing, and pattern), they adjust spreads wider.

This doesn't violate any rules—it's legitimate market-making practice. But it means your trading activities are more transparent to market makers than you might realize.

The implication: Assume that your trading information is at least partially visible to market makers. This should discourage large, obvious orders and encourage: (1) splitting large orders into multiple smaller orders, (2) using limit orders rather than market orders, and (3) trading when order flow is busy (when your order is harder to distinguish from others').

Real-World Examples of These Mistakes​

Example 1: Robinhood customer and execution quality: A retail trader used Robinhood for commission-free trading, not realizing that Robinhood routes to market makers paying PFOF rather than offering the best prices. Over a year of trading, the trader executed approximately 200 trades totaling $500,000 in turnover. Due to worse execution quality relative to a Fidelity account, the trader lost an estimated $2,000-3,000 in foregone better execution. This was 0.4-0.6% of turnover or 10-15% of their annual trading profit before costs.

Example 2: Options trader underestimating spreads: An options trader bought one-week-out call options expecting to profit from anticipated volatility. Over 10 trades with an average trade size of 5 contracts and an average option price of $0.50, the trader paid an estimated $0.10 per contract in total transaction costs (spread plus adverse selection). This was 20% of the option premium—paid before realizing any profit. The trader's actual trading edge needed to be substantial (more than 20%) just to break even after costs.

Example 3: Liquidity evaporation: A trader held a position in a mid-cap stock (normal spread 2 cents, normal daily volume 100,000 shares). During a market-wide volatility spike in October 2023, the spread widened to 20 cents and volume dried up. The trader, wanting to exit, faced a choice: sell at $10 worse than the previous closing price or hold through continued uncertainty. The trader learned that liquidity can evaporate exactly when you need it most.

Common Mistakes​

Treating trading as a zero-sum game you can win: The reality is that markets are negative-sum for small traders (due to transaction costs, taxes, and competition). The deck is stacked against you before you even start.

Focusing on stock-picking instead of costs: Many retail traders obsess over which stocks to buy but neglect trading costs, taxes, and fees. Reducing the latter matters more than marginal improvements in stock-picking skill.

Blaming yourself for poor execution instead of examining broker choice: If your execution quality is poor, your first investigation should be your broker's routing practices, not assumptions that you executed wrong.

Assuming past trading success will continue: A retail trader who has had a profitable period might attribute this to skill, not realizing luck and favorable market conditions played major roles. This leads to overconfidence and increased risk-taking.

FAQ​

Do market makers deliberately manipulate prices against retail traders?

Market makers don't deliberately manipulate in the legal sense, but they do structure quotes to maximize profit from retail traders. They widen spreads against traders they identify as uninformed and adjust quotes based on order flow they observe. This isn't manipulation but isn't neutral either.

Can I reduce my disadvantage against market makers?

Partially. You can: (1) choose brokers with better execution quality, (2) trade highly liquid securities, (3) use limit orders to avoid slippage, (4) avoid trading around earnings and volatility events, and (5) trade less frequently. However, information asymmetry and inventory cost differences mean retail traders face structural disadvantages that can't be fully eliminated.

Should I use a broker that participates in payment-for-order-flow?

If you have a choice, use a broker that doesn't prioritize PFOF or offers alternative routing options. Brokers like Fidelity and Vanguard offer better execution quality than pure PFOF brokers like Robinhood. However, if PFOF is what enables commission-free trading you value, the tradeoff might be acceptable if you trade infrequently.

How much do transaction costs really matter?

For buy-and-hold investors trading infrequently, they're negligible (less than 0.1% annually). For active traders executing dozens of trades monthly, they can amount to 5-10% annually. For day traders, they're the primary cost and often ensure net losses.

Is it possible to profit consistently as a retail trader?

Yes, but it's difficult. A tiny percentage of retail traders do profit, likely through a combination of skill and survivorship bias. If you believe you can be in this percentile, you should have substantial evidence from years of consistent outperformance.

Do I have any advantages over market makers?

Your main advantage is time horizon. Market makers optimize for short-term profit over microseconds to hours. If you're investing for years to decades, you can profit from macroeconomic trends that market makers ignore. Additionally, you have access to the same financial statements and macroeconomic data as institutional investors.

How can I tell if my broker is routing my orders fairly?

Look at their published execution quality statistics (most brokers publish these quarterly). Compare execution prices you receive to the national best bid-ask quotes reported by your broker. If you consistently see worse execution, change brokers.

Summary​

Retail investors make systematic mistakes about market makers that cost them money collectively in the billions annually. These mistakes stem from misunderstandings about: (1) brokers' neutral role and incentives (they have financial incentives to route to less favorable market makers), (2) the permanence of liquidity (spreads widen and disappear during stress), (3) transaction costs (they extend far beyond the quoted spread and compound across many trades), (4) execution quality differences across brokers (they're substantial and measurable), (5) information asymmetries (market makers exploit them systematically), (6) liquidity permanence (it evaporates during crises), (7) where market-maker profits come from (they come directly from retail trader wallets), (8) the possibility of beating market makers through skill (it's far more difficult than retail traders assume), (9) options market dynamics (spreads are much wider due to hedging costs), and (10) order flow visibility (it's greater than retail traders assume). Understanding these realities doesn't require becoming sophisticated but does require honestly assessing your trading edge and the structural disadvantages you face. For most retail investors, the honest assessment is that active trading against market makers is a negative-expected-value activity, and passive indexing is a superior strategy. For the minority of retail traders with genuine edges and the discipline to exploit them, understanding market-maker dynamics is essential for minimizing unnecessary costs.

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