How does a dealer (or market maker) earn the bid-ask spread on a stock?

Question

1. If I am correct, dealers purchase assets for their own accounts, and later sell them for a profit from their inventory. But the spreads is the difference between buy (or "bid") prices and sell (or "ask") prices at the same time. So how can dealers earn the bid-ask spread?

2. From Investopedia's Bid-Ask Spread page:

   The size of the spread from one asset to another will differ mainly because of the difference in liquidity of each asset.

   Since the spread is taken away by the dealers, how can it represent the difference in liquidity of the two assets?

Answer 1

1. Market-makers (which you term dealers) earn the bid-ask spread by buying and selling in as short a window as possible, hopefully before the prices have moved too much. It is not riskless. The spread is actually compensation for this risk. From The Race to Zero:

   The market-maker faces two types of problem. One is an inventory-management problem – how much stock to hold and at what price to buy and sell. The market-maker earns a bid-ask spread in return for solving this problem since they bear the risk that their inventory loses value.

   Market-makers face a second, information-management problem. This arises from the possibility of trading with someone better informed about true prices than themselves – an adverse selection risk. Again, the market-maker earns a bid-ask spread to protect against this informational risk.

   The bid-ask spread, then, is the market-makers’ insurance premium. It provides protection against risks from a depreciating or mis-priced inventory. As such, it also proxies the “liquidity” of the market – that is, its ability to absorb buy and sell orders and execute them without an impact on price. A wider bid-ask spread implies greater risk in the sense of the market’s ability to absorb volume without affecting prices.

2. The less liquid an asset is, the more time is likely to pass (and hence more information likely to arrive) until someone comes along to take the inventory from the dealer, and the greater is the risk that the price will have changed in the mean time. Since spread is compensation for this risk, ceteris paribus spreads are wider for less liquid assets.

Answer 2

Every merchant makes money by buying wholesale, and selling retail. In the case of a market maker, the "bid" is the "wholesale" price, and the "ask" is the retail price.

In "real life," the difference between wholesale and retail depends on how quickly something sells. High volume items like gasoline and milk have narrow spreads between wholesale and retail because they sell quickly. Low volume items like furniture and cars sell slowly, and thus have much larger spreads. The same is true for high and low volume stocks.

In the case of IBM, the bid-asked spread might be a penny (or less). If the dealer can buy-sell one million shares of IBM, he'll make 1 million pennies, or $10,000, in a short period of time. Other stocks trade only a few thousand shares a day. In that case, the spread might be five, ten cents or even more, just to make it worthwhile for the dealer to trade them.

Answer 3

Market makers make the spread on market orders, only. A market order is one in which the retail buyer/seller says fill the order immediately at whatever is the best price. The market maker is buying the market-sells at the bid and selling the market-buys at the ask. If the market-buy volume equals the market-sell volume then the market maker is just transferring shares between market-buyers and market-sellers and pocketing the the bid-ask spread (in addition to commissions.) Limit-buy orders are filled when limit-sellers drop their asking price and limit-sell orders are filled when limit-buyers raise their bid. The market maker makes only commission on limit orders but limit orders define the bid-ask spread.