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Market Makers During Volatility

When markets turn turbulent, the first thing many investors notice is that spreads widen dramatically. The stock they could have bought at $100.00 / $100.01 moments ago now shows bids at $99.50 and asks at $100.50. More troubling, some stocks show no quotes at all—market makers have simply withdrawn. Where did the liquidity go? Why do market makers, whose business is providing liquidity, seem to disappear precisely when liquidity is most needed?

The answer reveals something fundamental about market making: it's a business that depends on low volatility. When volatility spikes, the economic incentives that drive market making flip. What was profitable becomes dangerous. What was manageable becomes catastrophic. Understanding how market makers respond to volatility—why they widen spreads, reduce inventory, and sometimes exit the market entirely—is crucial for understanding how modern equity markets function during stress.

Quick definition: Market-maker behavior during volatility includes widening spreads, reducing inventory holdings, tightening quoted sizes, and potentially withdrawing from the market as the risks of holding inventory increase and adverse selection risk spikes.

Key Takeaways​

  • Volatility increases both inventory risk and adverse selection risk simultaneously, creating a double squeeze on market makers
  • Spreads typically widen 5-10x during moderate volatility spikes, and 20-50x during extreme volatility
  • Market makers reduce their inventory holdings during volatility, accepting less profitable trading volume
  • Quoted sizes (the number of shares a market maker will buy or sell at posted prices) shrink during volatility
  • Electronic market makers can adjust quickly to volatility, but human traders and traditional dealers lag, creating operational stress
  • Circuit breakers and trading halts provide temporary relief, giving market makers time to rebalance
  • Extreme volatility can force market makers to exit the market, causing liquidity collapse and potentially triggering further price cascades

The Double Squeeze: Inventory Risk and Adverse Selection Risk​

When volatility spikes, market makers face two simultaneous pressures that push in the same direction: toward wider spreads and smaller inventory positions.

Inventory risk increases: When a stock's volatility doubles, a market maker's potential loss from holding inventory roughly doubles (or increases by the square root of volatility increase, to be precise). A position worth $5 million that could lose $50,000 per hour in low volatility might lose $100,000 per hour in high volatility. This directly increases inventory risk costs and justifies wider spreads.

Adverse selection risk increases: When volatility spikes, information asymmetry often increases simultaneously. The sudden volatility suggests something has changed about the stock's risk profile or fundamentals. Traders with better analysis or earlier access to information (or perception of it) are more likely to show up and trade. Market makers, sensing this increased adverse selection risk, widen spreads further.

The combination is powerful. Where inventory risk alone might justify a 2-cent widening, and adverse selection risk alone might justify another 2-cent widening, together they create a 4-5 cent widening. In extreme cases, the effects compound further.

Consider a concrete example:

Normal volatility day: Apple trades with 20% annualized volatility. Spreads are 1 cent. Market makers maintain positions of 100,000 shares. Inventory turnover is rapid, and risk is manageable.

Moderate volatility day: An unexpected product announcement creates concern, and volatility spikes to 40% annualized. Spreads widen to 3-5 cents. Market makers reduce inventory holdings to 50,000 shares. Inventory turnover slows as they become more selective about orders they'll accept.

Extreme volatility day: A major market crash or geopolitical shock causes volatility to spike to 100%+ annualized. Spreads widen to 15-25 cents or wider. Market makers reduce inventory to near-zero and may withdraw quotes entirely. Some traders are unable to execute at any price.

How Spreads Respond to Volatility​

The relationship between volatility and spreads is so consistent that researchers have developed mathematical models to predict spreads from volatility. The roll model and other market microstructure models show that spreads should scale roughly with:

Spread ≈ Volatility × sqrt(Time Holding Inventory) + Adverse Selection Cost + Operational Cost

When volatility doubles, spreads should roughly increase by the square root of 2 (about 40%) from the inventory risk component alone. In reality, spreads often increase much more because adverse selection risk also increases.

Empirically, researchers have documented:

  • In moderate volatility increases (volatility goes from 20% to 30% annualized), spreads widen by 20-30%
  • In significant volatility increases (volatility doubles), spreads widen by 50-100%
  • In extreme volatility (volatility increases 5-10x), spreads widen 5-20x

The 2008 financial crisis saw spreads in major equity indices increase from 0.01% of stock price (1 cent on a $100 stock) to 0.2% or more (20 cents on a $100 stock)—a 20x increase as volatility exploded.

The March 2020 COVID crash saw similar spread widening, with some securities experiencing temporary bid-ask gaps (no quotes at all) or inverted spreads (bid higher than ask) as market makers completely exited.

Inventory Management During Volatility​

In calm markets, market makers can tolerate some inventory imbalance, holding long or short positions for hours or even days. The carrying costs and risk are manageable.

During volatility, the calculation changes. A market maker holding a large position during high volatility faces the prospect of large losses. The incentive to reduce inventory becomes overwhelming.

Market makers adjust inventory through several mechanisms:

Asymmetric quotes: When a market maker holds excess long inventory and volatility spikes, they tighten their bid (the price they offer to buy) and widen their ask (the price they demand to sell). This asymmetry discourages selling to them (which would increase their long position) and encourages buying from them (which would reduce it).

If a market maker normally quotes "Buy 1,000 @ $100.00 / Sell 1,000 @ $100.01," during volatility with excess long inventory they might quote "Buy 500 @ $99.90 / Sell 1,000 @ $100.10." This asymmetry is a strong signal that the market maker wants to reduce their position.

Size reductions: Market makers reduce the quoted size during volatility. Instead of quoting "Buy 1,000 @ $100.00," they might quote "Buy 100 @ $100.00." This keeps them liquid enough to execute some trades but reduces their exposure per trade.

Inventory liquidation: Market makers actively seek to liquidate inventory during volatility, often at costs. They might hit bids more aggressively than normal or post offers to sell at discounted prices to ensure they can reduce inventory.

Order selectivity: Market makers become selective about which orders they accept. They favor orders that move their inventory toward target (toward zero balance). They may decline orders that would move them further from target.

Withdrawal from the market: In extreme volatility, market makers may simply stop quoting in the security entirely, effectively removing themselves from the market until volatility subsides.

Quoted Sizes and Availability​

A subtle but important aspect of market-maker behavior during volatility is the change in quoted sizes. Most investors focus on bid-ask spreads and fail to notice that the number of shares a market maker will transact at posted prices has also changed.

In normal times, a market maker quotes "Buy 1,000 @ $100.00 / Sell 1,000 @ $100.01." A trader can be confident buying or selling up to 1,000 shares at these prices.

During volatility, the quote might become "Buy 100 @ $99.99 / Sell 100 @ $100.01." The spread is only 2 cents, similar to normal. But the trader can only execute 100 shares at these prices. If they want to buy 1,000 shares, they'll buy 100 at $100.01, then find the next best bid is, say, $99.98, and have to buy another 100 at that worse price. The effective cost of their full 1,000-share purchase is worse than if they'd traded during calm periods.

This reduction in quoted size is not an accident—it's a direct response to volatility. By reducing quoted size, market makers reduce their per-trade exposure to adverse selection and inventory risk. A market maker would rather execute 100 shares at a time and turn their portfolio over 10 times than execute 1,000 shares and risk being left with inventory for hours.

The Relationship Between Volatility and Order Flow​

Volatility and order flow are intertwined in complex ways. When volatility spikes, it often triggers order flow imbalances. During market declines, selling pressure builds as investors panic. During market rallies, buying pressure increases as fear of missing out drives traders.

Market makers observe this imbalance and interpret it as information. If all incoming orders are selling, they suspect bad news is coming. They widen spreads and tighten bids further, trying to avoid accumulating excess inventory.

The phenomenon creates a feedback loop:

  1. Some event triggers volatility
  2. Volatility increases inventory risk and adverse selection risk
  3. Market makers widen spreads and reduce inventory
  4. Wider spreads and reduced willingness to trade encourages traders to use more aggressive execution strategies
  5. More aggressive strategies create more market impact and more volatility
  6. Volatility spirals upward

This feedback loop is why volatility often spikes in discontinuous jumps rather than smooth increases. One trader's decision to liquidate at market prices hits a market maker at full force. The market maker responds by widening spreads, forcing the next trader to accept worse prices, forcing the next trader to be more aggressive, and so on.

Circuit breakers and trading halts interrupt this spiral by halting trading for a period, allowing emotions to cool and giving market makers time to rebalance.

Electronic Market Makers vs. Traditional Dealers​

The rise of electronic market makers—algorithmic trading systems that adjust quotes automatically—has changed how markets respond to volatility, but not eliminated the fundamental problem.

Electronic advantage: Algorithmic market makers can adjust spreads and quoted sizes in milliseconds. When volatility spikes, their systems immediately detect it and adjust quotes. This speed allows them to reduce their exposure faster than human traders can.

Traditional disadvantage: Traditional dealers and floor traders on exchanges like the NYSE adjust more slowly. A human Designated Market Maker must interpret the market movement, calculate an appropriate spread adjustment, and input new quotes. This takes seconds to minutes.

The speed advantage of electronic market makers has compressed spreads during normal times. But during stress, when volatility changes faster than traders can react, the advantage disappears. Even fast algorithms can't adjust faster than price moves if price moves are sharp enough.

The March 2020 crash illustrated this. Despite the prevalence of electronic market makers, spreads still widened dramatically because volatility moved too fast for even algorithmic systems to adjust instantaneously. Some securities experienced trading halts because spreads became so wide that orderly trading was impossible.

Why Market Makers Exit During Volatility​

The most extreme form of market-maker response to volatility is complete withdrawal—stopping all quoting and trading in a security. This seems counterintuitive. If volatility spikes and spreads widen dramatically, aren't there large profits to be made? Why would market makers exit?

The answer involves the rational exit decision. A market maker faces a choice during extreme volatility:

Choice 1: Stay and quote very wide spreads If they quote, say, a 50-cent spread in a stock trading at $100, they capture $0.50 per round-trip trade. But they face:

  • Extreme inventory risk (each trade adds to inventory that could move against them)
  • Extreme adverse selection risk (traders showing up during chaos are likely informed)
  • Potential for massive losses if they're wrong about fair value
  • Regulatory obligations that might force them to execute at quoted prices even if those prices become uneconomical

Choice 2: Withdraw and not quote If they stop quoting, they:

  • Avoid the risk of being stuck with inventory they can't liquidate
  • Avoid the adverse selection risk of trading during chaos
  • Protect their capital for when markets stabilize
  • Accept the opportunity cost of missing potential profits

The rational choice depends on the magnitude of potential losses vs. potential gains. During extremely volatile conditions, potential losses can easily exceed potential gains. A market maker facing a 50% probability of losing $500,000 and a 50% probability of gaining $200,000 will rationally exit rather than stay.

Real-World Examples of Volatility and Spreads​

The March 16, 2020 COVID Crash: On March 16, 2020, realized volatility in the S&P 500 exceeded 150% annualized. Spreads in major index ETFs (SPY, QQQ) widened from 1 cent to 10-20 cents. In individual stocks, spreads ranged from 10 cents to over $1.00. Several market makers halted quoting in certain securities. The Fed's subsequent intervention in bond markets eventually stabilized conditions.

The August 5, 2011 Flash-Point Event: A sharp intraday decline triggered by sovereign debt concerns caused volatility to spike. Market makers reduced inventory and widened spreads. Spreads in some stocks widened from 1 cent to 5-15 cents.

Tesla (TSLA) Volatility Spikes: Tesla regularly experiences volatility spikes of 100%+ annualized around earnings announcements, Elon Musk tweets, and other catalysts. When volatility spikes, TSLA spreads widen from 2-3 cents to 10-30 cents. Market makers reduce inventory and become selective about which orders to accept.

Leveraged ETF Crashes: Inverse ETFs and 3x-leveraged ETFs occasionally experience crashes where prices diverge sharply from their intended tracking levels. During these crashes, spreads in the affected ETFs widen dramatically as market makers, uncertain of fair value, stop quoting.

How Regulators and Exchanges Respond​

Recognizing that market-maker withdrawal during volatility can be damaging to overall market function, regulators and exchanges have implemented several measures:

Circuit Breakers: Automatic trading halts that trigger when the market declines more than a certain percentage (typically 7%, 13%, or 20%) in a single day. The halt gives market makers and traders time to reassess and rebalance. This interrupts the feedback loop of volatility-driven order flow.

Quoting Obligations with Volatility Adjustments: Exchanges allow market makers to adjust their quoting obligations during extreme volatility. Instead of requiring a 1-penny spread on 1,000 shares, exchanges might temporarily allow a 5-penny spread on 100 shares.

Market Maker Stability Programs: Some exchanges have programs that provide financial incentives to market makers who maintain sufficient quotes during volatile periods.

Order Size Limitations: Exchanges may limit the maximum size of individual orders during volatile periods to prevent large single orders from overwhelming market makers.

Information Feeds: Exchanges provide real-time volatility and stress indicators to market makers, allowing them to better assess market conditions and adjust proactively.

Regulatory Capital Relief: Banking regulators may temporarily relax capital requirements for market makers during stress periods, allowing them to hold larger inventories and maintain quoting obligations.

The Paradox of Volatility and Liquidity​

The central paradox of market making during volatility is that liquidity—the availability of counterparties to trade—is most valuable when it's scarcest. During calm, stable periods, liquidity is abundant and cheap (spreads are tight). During volatile, stressful periods, liquidity is scarce and expensive (spreads are wide) or unavailable.

This paradox exists because liquidity provision during stress is genuinely costly. Market makers face real, quantifiable risks. Widening spreads is not market makers being greedy—it's compensation for those real risks.

However, the paradox creates a policy dilemma. If regulators force spreads to stay tight during volatility, market makers face uncompensated risks and exit the market, harming liquidity. If regulators allow spreads to widen freely, traders incur large costs during the times they most need to rebalance or protect themselves.

Regulators attempt to balance this through circuit breakers (which create natural pause points), quoting obligation adjustments (which allow spreads to widen but not too much), and counter-cyclical capital requirements (which allow market makers to maintain inventory during stress without excessive regulatory burden).

The Technology Factor: How Modern Systems Respond to Volatility​

Modern market-making technology has changed how markets respond to volatility. Algorithmic systems can adjust spreads and inventory positions faster than humans can. They can monitor multiple venues simultaneously and route orders to the most liquid venues.

But technology has also created new risks:

Procyclicality: Algorithms that reduce inventory during volatility do so automatically and simultaneously. When many algorithms adjust at once, it can amplify volatility rather than dampening it.

Model Risk: Algorithms depend on models that were calibrated during historical periods. When volatility exceeds historical experience (as happened in March 2020), algorithms may malfunction or make poor decisions.

Systemic Risk: The widespread use of similar algorithms means market makers may behave too similarly, reducing diversity and amplifying volatility cascades.

Flash Crashes: Algorithmic interactions can sometimes trigger flash crashes—sudden, sharp declines and recoveries that occur in seconds or minutes.

These risks have prompted regulators to implement circuit breakers on individual stocks (trading halts when individual stocks move too fast), market-wide circuit breakers, and algorithmic trading regulations that require transparency and reasonable error checks.

FAQ​

Q: Is it true that market makers are trying to crash the market during volatility? A: No. Market makers are responding rationally to increased risk. They're not trying to crash the market; they're trying to survive during a market crash. Their withdrawal of liquidity is a symptom of the crash, not a cause.

Q: Can market makers be forced to stay in the market during volatility? A: Regulations like quoting obligations do require market makers to maintain some minimum quote in designated stocks. But these are adjusted during extreme volatility. Markets recognize that if the requirements are too onerous, market makers will exit the industry entirely.

Q: Why don't retail investors benefit from wider spreads during volatility? A: They should benefit—wider spreads compensate market makers for higher risk, and this is the cost of trading during chaos. But retail investors often don't think of it as a benefit. They experience it as a cost (worse execution) rather than as compensation market makers require.

Q: How do market makers handle inventory overnight during volatile periods? A: Market makers try to avoid holding inventory overnight. If volatility is high and they have excess inventory at market close, they may liquidate at any price to avoid holding overnight. This can create sharp price movements at market close.

Q: Do spreads ever get so wide that trades don't happen? A: Yes. In extreme volatility, spreads can widen so much that traders prefer not to trade, effectively freezing the market. Trading halts are used to prevent this from becoming too extreme.

Q: What's the difference between spread widening and bid-ask inversion? A: Spreads widening means the gap between bid and ask increases (bid goes down, ask goes up). Bid-ask inversion means the bid exceeds the ask—prices go backwards. This is a sign of complete market breakdown and is rare.

Q: Do market makers profit during volatility? A: In some cases, yes. Market makers who predict volatility correctly and position themselves accordingly can profit. But many market makers suffer losses during extreme volatility, particularly if they misjudge fair value.

  • Circuit Breakers: Automatic trading halts that interrupt volatility feedback loops
  • Value at Risk (VaR): A statistical measure of potential losses that market makers use to manage volatility risk
  • Bid-Ask Bounce: Price oscillation driven by the bid-ask spread itself during volatile periods
  • Market Microstructure: The study of how trading mechanism and information interact to determine spreads and prices
  • Liquidity Crisis: Severe reduction in trading volume and liquidity during market stress
  • Volatility Clustering: The empirical finding that high volatility tends to be followed by more high volatility

External Resources​

Market stability and volatility research:

Summary​

Market makers during volatility face a fundamental economic problem: holding inventory becomes progressively riskier as volatility increases. Both inventory risk and adverse selection risk increase simultaneously, creating a double squeeze that forces market makers to widen spreads and reduce inventory.

The result is that liquidity—measured by how tight spreads are and how much size a market maker will transact—becomes scarce precisely when it's most needed. This paradox is not a failure of market makers, but rather a reflection of the real economics of liquidity provision. Spreads must widen during volatility to compensate market makers for the increased risk they face.

Regulatory mechanisms like circuit breakers, adjusted quoting obligations, and counter-cyclical capital requirements attempt to balance the need for market makers to be protected against catastrophic losses with the need for liquidity to remain available during stress.

Understanding market-maker behavior during volatility is essential for understanding why market stress often occurs in discrete jumps, why spreads widen so sharply, and why trading sometimes halts entirely.

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When Market Makers Pull Quotes