Thursday, November 20, 2008

Random Thoughts on Market Making

A market maker might buy stock at the bid and sells at the ask and by doing so creates a market. At the time he gives his bid and ask quotes he does not know what the trader is going to do. The market maker increases liquidity since if a trader wants to trade he does not need to look for the counterparty who want to enter the opposite transaction. The markets maker buys low and sells high and make a profit, i.e., his profit or loss is depended on how low he bought the asset and how high he sold it.
The buying and selling may not happen in the same time therefore he has to maintain an inventory of assets to meet the trading requirements. Also we should be mindful that the market may not be trading on actual valuation. Also when a market maker buys a stock and liquidates his position the market price might have changed.
Therefore the factors affecting his profits are:
  • Bid and ask prices at which items were bought
  • How fast he can turn over his inventory
  • Exposure on his inventory
Out of these factors, what he can explicitly control in the spread again subjected to a maximum.
In order to achieve a high turnover and low inventories (thus reducing market exposures), a market making strategy should concentrate on balancing the liquidity supply and demand through setting the spreads.
If he is to manage his inventory he has to look at the number of sells and buys and put his spreads adjusting for buying and selling pressure in the market and against this inventory at the currently prevailing prices and the liquidity absorbed by other market makers and participants. When supply pressure in the market increases / decreases he should decrease / increase the bid and when demand pressure market increase / decrease he should increase / decrease the ask. Also he would have buy and selling pressure against this inventory based on large order he has to fill and the risk exposure on it.
The market pressures can be determined through the order book interaction with other MMs. The distribution of trades in the order book would help a MM to determine on how to setup his bid and ask. If a MM does not want to participate in either a buy or a sell, he can adjust the bid or ask accordingly so that there is a higher chance that another MM would be chosen undesirable transaction.
A market maker will have to fill various order. This would increase his buying and selling pressure. Also he has to asses the risk on the inventory in terms of price changes during his holding period and liquidity (determines the holding period and how fast he can turn around his inventory.)
To rap up, market makers are not in a position to trade on valuation. The profit he makes is based on how effectively a MM handles the supply and demand pressures through his spreads, not necessarily through setting it through a valuation basis like straddling the top and bottom of the market.
Suminda Sirinath Salpitikorala Dharmasena

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