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making 2 sided markets


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making 2 sided markets

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  #1 (permalink)
Jamie818
Toronto ON/Canada
 
 
Posts: 8 since Mar 2017
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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.

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  #3 (permalink)
 choke35 
Germany
 
Experience: Intermediate
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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.

What is unclear about that?

If you buy the ES at 2387.5 and sell it at 2387.75, your profit is $12.5 less commissions (near 0 because MMs regularly
are members of the respective exchanges). In stocks, the spread often is larger than 1 tick, so the net profits are much higher if it is you who gets the trade.

Why HFT? - The more often you do these trades, the more you earn.
What's the precondition? - Regulatory issues aside, if you have got some 7- to 9-figure bucks left, feel free to
invest in HFT, exchange seats, colocation etc. and play heads-up with the big guys

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  #4 (permalink)
Jamie818
Toronto ON/Canada
 
 
Posts: 8 since Mar 2017
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Hello choke35, yes but this assumes the market moves higher since the ask is normally higher than the bid, and forgive me if this sounds silly but I was under the impression that MM's could do business without the market moving. So they are really just doing what the rest of us are then. I think I will have to play in my corner of the sandbox for the time being but I will keep that colo HFT thing in mind should an extra 50 mil fall into my lap, thanks.

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  #5 (permalink)
 choke35 
Germany
 
Experience: Intermediate
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Jamie818 View Post
...forgive me if this sounds silly but I was under the impression that MM's could do business without the market moving.

For any given moment in exchange time there is a spread. So your perspective is just a bit narrow.
The question is if anyone crosses the spread (i.e. is willing to pay it for whatever reason) and that's
where the beef is.

From then on the only question is if it is you who gets the trade. - Thus these massive invests in hightech
just to shave off some microseconds, because the runner-up in this race gets zilch.

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  #6 (permalink)
Jamie818
Toronto ON/Canada
 
 
Posts: 8 since Mar 2017
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Thanks, I shall try to wrap my mind around all this. There was good recent podcast on Chat With Trader featuring former HFT guy Dave Lauer that you may be interested in if you have not given it a listen, though there may not be much info there you don't know.

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  #7 (permalink)
 artemiso 
New York, NY
 
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Jamie818 View Post
Hello choke35, yes but this assumes the market moves higher since the ask is normally higher than the bid, and forgive me if this sounds silly but I was under the impression that MM's could do business without the market moving. So they are really just doing what the rest of us are then. I think I will have to play in my corner of the sandbox for the time being but I will keep that colo HFT thing in mind should an extra 50 mil fall into my lap, thanks.

You don't need 50M to be successful at market making. It obviously gives you a lot more room to make mistakes and is a strong predictor of success if you are well-funded, but I've seen successful operations start with a fraction of that. What you absolutely need, however, is a good amount of intelligence, diligence, and luck.

There's many things missing from the picture painted by your usual industry survey that says you just buy at the bid and sell at the offer, and you're correct that it's not as simple as it sounds. Without going into detail, the main things that come to mind:

1. If you get a buy at the bid, chances are that the fair value of the product is less than your buy price. A corollary of this is that if you get a buy at the bid, chances are that no one wants to take you out of the trade at the offer.

2. If there's a buy at the bid, chances are that you're not the one who got filled.

Many of the technological pursuits that you hear about, e.g. colocation, are really just means to deal with these 2 problems.

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  #8 (permalink)
 tpredictor 
North Carolina
 
Experience: Beginner
Platform: NinjaTrader, Tradestation
Trading: 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.


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  #9 (permalink)
Jamie818
Toronto ON/Canada
 
 
Posts: 8 since Mar 2017
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Thanks tpredictor, yes I was aware of the level 3 depth that MM's enjoy (stops are visible). Is there any good book you know of on modern market structure? The Larry Harris book is said to be good but outdated now as it lacks info on dark pool HFT activity.

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  #10 (permalink)
convextrading
New York, NY
 
 
Posts: 5 since May 2017
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There is no data feed which shows stop orders. Typically, stop orders aren't supported by the exchange but instead, they ate held by your trading platform / broker until the stop condition is triggered at which time a market or limit order is sent to the exchange. The existence of an exchange feeds which lets others see your stop orders is a persistent myth but isn't true.

As a note, your *broker* may be able to see your stop orders, though I imagine they aren't allowed to act on it. In cases when you're not trading on a public exchange but against the broker (like in some FX setups, CFDs, etc) the above doesn't hold and unsavory things do occur (see the FXCM settlement).

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  #11 (permalink)
Jamie818
Toronto ON/Canada
 
 
Posts: 8 since Mar 2017
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Hello convex, Thank you for your reply and information. That is interesting , assuming you are correct then it is indeed a widespread myth. Martha Stokes at stockcharts.com goes on and on about how "it's not the market makers running your stops-- it's the HFT's. They are wired right to the exchange and they see all that info. They are the ones ripping you off." But then what would you say to allegations that HFT's employ stop hunting techniques such as "momentum ignition"? If they cannot see stop orders resting in the book what are they basing their strategy off-- simply a hunch based off significant previous swing area?

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  #12 (permalink)
convextrading
New York, NY
 
 
Posts: 5 since May 2017
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The specs for the datafeeds available to HFTs are typically available on the web. For example the CME direct feed is MDP 3 and the section of documentation relevant to order book feeds can be found as the first google response to "mdp3 book management" (I'd post a link but I don't have enough posts on this forum to be allowed to). If you look through that, you'll see that stop orders are nowhere there. In fact, not only are stop orders not there but even some limit orders ("Iceberg" or "reserve" orders are hidden in all dataefeds as well).

I suspect that in reality, nobody is actually hunting your stops but rather, they are either picking up on statistical signals or even more likely, you are attributing malice to random movements of the market. What I mean by picking up by statistical signals is that a pattern of "When a size X order, submitted at a latency insensitive time (so probably not by an algo) trades and the price moves Y against it, there's a Z % chance to see an aggressive size-X order reversing the position" isn't exactly rocket science. Even then, those indicators typically go into a predictive model as to what the "fair price" is, so if the market starts falling for other reason's, the algo trader will know that there's a hidden sell order coming soon and will adjust its fair valuation accordingly; I don't believe people are aggressively moving markets in order to induce stop orders but rather just moving their fair-value valuations to adjust for the information.

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  #13 (permalink)
 Alexander Savin 
Europe
 
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convextrading View Post
"When a size X order, submitted at a latency insensitive time (so probably not by an algo) trades and the price moves Y against it, there's a Z % chance to see an aggressive size-X order reversing the position"


I'd call that stop hunting. Semantics...



Sent from my iPhone using futures.io

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  #14 (permalink)
convextrading
New York, NY
 
 
Posts: 5 since May 2017
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Call it what you will, my point is that the stop orders are not transmitted in the datafeed (at least not before they get triggered and become limit / market orders). Furthermore, what I intended to say is "most likely nobody is noticing or cares about your stops but if they are, this is how they could do it" so yes, the "if they are this is how they can do it" part can be called stop hunting if you want.


Alexander Savin View Post
I'd call that stop hunting. Semantics...


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