Security dealers maintain a continuous presence in the market and stand ready to buy and sell securities immediately from impatient sellers and buyers. Dealers are willing to buy securities at a price slightly below the perceived equilibrium price (i.e. bid price) and sell securities immediately at a price slightly above the perceived equilibrium price (i.e. ask price). Of course, buyers and sellers of securities could wait to see if they can locate counterparties who are willing to sell or buy at the current equilibrium price. However, there are risks associated with patience. The equilibrium price may change “adversely” in the interim such that it is either higher or lower than the dealer’s current bid or ask quotes. Thus, the willingness of traders to transact at a price that differs from the perceived equilibrium price compensates market makers, in part, for the risks of continuously supplying patience to the market. Although the dealers’ willingness to post bid and ask quotes springs from their self-interest, their actions generate a positive externality of greater liquidity for the market as a whole.
In general, the bid-ask spread compensates the dealer/market makers for three costs that attend their function of providing liquidity. These costs include order-processing costs, inventory control costs, and adverse selection costs. The order processing costs include maintaining a continuous presence in the market and the administrative costs of exchanging titles (Demsetz, 1968). The inventory control costs are incurred because the dealer holds an undiversified portfolio (see e.g. Amihud and Mendelson, 1986; Ho and Stoll, 1980). The adverse selection costs compensate the dealer for the risk of trading with individuals who possess superior information about the security’s equilibrium price (see e.g. Copeland and Galai, 1983; Glosten and Milgrom, 1985).
A dealer’s quote has two component parts. The first part is the bid and ask prices. The second part is the quotation size which represents the number of shares dealers are willing to buy (sell) at the bid (ask) price. A dealer’s quote can be described as an option position (Copeland and Galai, 1983). To wit, the bid and ask price quotes are a pair of options of indefinite maturity written by the dealer. A put (call) option is written with a striking price equal to the bid (ask) price. The quotation size is the number of shares dealers are willing to buy (sell) at the bid (ask) price. Simply put, the quotation size represents the number of put (call) options written with a striking price equal to the bid (as k) price.
In the parlance of options, the dealer’s position is a short strangle. A strangle consists of a call and a put on the same stock with the same expiration date and different striking prices. The call (put) has a striking price (below) the current stock price. Dealers are short a strangle since they write both options. If one assumes the dealer’s bid and ask prices bracket the market’s estimate of the stock’s current equilibrium price, the analogy is complete.
