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making 2 sided markets

  #8 (permalink)

North Carolina
Trading Experience: Beginner
Platform: NinjaTrader, Tradestation
Favorite Futures: es
Posts: 644 since Nov 2011

Below are some common views on the matter...

A. In futures markets, a trader can offer liquidity, i.e. use limit orders, but not be a traditional market maker in the sense that they aren't forced to make markets. A firm could run a lot of strategies that buy bid/sell ask but only when their models are programmed to do so.

B. Traditional prop firms/market makers are believed to need a lot of capital because they keep a lot of orders out all the time. This allows them queue advantage. So, they are on top of book. This is important because the best orders to fade are the ones that aren't able to drive the price. Imagine if you have enough orders to load both sides of the book. A bunch of small traders buy while another group sells but neither are able to move the price. In total, imagine 100 orders transact, you just made $12.50 * 100 = $1250-fees. On the other hand, if you try this as a retail trader you will be bottom of book, so the market is going to be much more likely to tick against you.

C. Some longer time frame traders might also trade in a passive way and also use limit orders, thus acting as market makers.

D. The sooner you place your order then the better your queue position. So, the question might become what is the advantage of HFT. Good question. The advantage is surely the ability to integrate that information and use it as intelligence. (There are some other types of queue algos.)

E. Market makers on exchanges/stocks may receive a rebate or other incentive. Traditional market makers can see the order flow in the stock that retail traders can't. This gives them a very, very exclusive advantage. However, they are required to make two sided markets. This is where the term market maker truly comes come: a trader with exclusive advantage but with a requirement to make orderly markets. Futures markets are different in the sense that such a participant doesn't truly exist.

F. Order types can be important when market making.

G. Part of the advantage in market making comes from the ability to exhaust the order flow and run the markets. This, yes, means manipulation. The manipulation is not absolute though. HFT traders may also use orders to obtain information.

H. Based on public reports on some traders (i.e. those with charges pending for manipulation), these sorts of traders may also use gaming such as fake depth on the book with special order types that won't be filled. They may flash this size at key points in the market and combine with their own orders to achieve an unfair advantage.

I. Traditional or naive market making is very similar to the idea of a "bookie". Imagine, a binary option or similar, where 50 people want to bet the market will rally while 50 bet it will go down, you act as a middle man. You quote 49/51. The traders who bet the market will go down will get a pay out of $49 if they are right. The traders who bet market will go up will get a payout of 100-51=$49 if they are right. The fair value was 50/50 bet in this case. Because you took 50 buys and 50 sells, you are perfectly hedged. You are guaranteed in this case to make $50. Now, imagine that 60 people bet the market will go up while only 40 bet it will go down. This is information but also to keep your book balanced, you will offer a reduced payout for the higher probability event but in any event your goal is to remain flat. In actuality, you will take risk in actual markets and have to constantly 'work' to remain proper book. You won't know all the orders coming in so you will have to constantly adjust your estimate of fair value throughout the day.

Jamie818 View Post
Hello futures io gang, I have a question regarding market making that perhaps someone could explain: how exactly in the most basic sense do you make money doing this? I have read countless times that MM's profit from the bid ask spread, and the larger that spread the better their return. I read in a congressional paper on HFT trading as a footnote that : "market makers buy on the ask and sell on the bid" but this means they buy high and sell low and make money? Clearly I am missing something here. Thanks to anyone who can help me or point me to an enlightening resource on this topic.

Last edited by tpredictor; May 10th, 2017 at 03:12 AM.
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