- Private Equity
With the advent of high-frequency trading (HFT), market making strategies have become increasingly algorithmic. Market making itself is not a new occurrence, but deployment of cutting-edge HFT technology has transformed the business. To help break things down, here’s an overview of some of the most common strategies.
As a refresher, a market maker is a firm or individual that trades both sides of a given security. The strategy aims to profit from both providing liquidity to other market participants and exploiting the bid/ask spread. However, when executing this strategy, the market maker avoids accumulating a large position in a single security.
Market makers operate on both the buy and sell sides of a security in order to earn the bid / ask spread, or the difference between the price the market is willing to sell a security at and the price the market is willing to buy a security at.
To earn a spread, the market maker will submit buy and sell orders on opposite sides of a security’s base price. To simplify, you can think of the base price as the market price.
A common strategy is for the market marker to submit limit buy/sell orders at the current best bid/ask prices. In this scenario, the mid-quote between the bid/ask is taken as the base price of the security.
With orders placed at both the bid and ask prices, the market maker’s bid/ask order spread is equal to that of the limit order book (LOB), the market’s record of unexecuted limit orders.
Sometimes market makers will submit orders at prices marginally higher than the bid and marginally lower than the ask in an attempt to gain order execution priority.
However, spreads in the limit order book (LOB) are often very tight, particularly with liquid equities, and leave little margin for profit. As a result, occasionally a market maker can lose money if their orders inadvertently hit the opposite side of the LOB.
Alternatively, a market maker could place their orders further into the LOB queue (lower bid and higher ask). This strategy, known as ask/bid-, produces higher margins, but also a lower order execution rate.
The alternative to the mid-quote strategy is the last price strategy. In this case, market makers will reference the last price a security traded at when determining the prices at which to place their bid and ask orders.
Referencing the last price traded, the market maker will submit bid and ask orders one or two ticks away in either direction.
Price quoting based on the Last Price methodology generally provides a higher return than the Mid-Quote methodology. However, this comes at the expense of higher end-of-day inventory of the given security
Market making strategies targeting quoting position (mid-quote and last price) work well when price action is relatively stable, but may run into difficulties during periods of sustained momentum or volatility.
For example, in a situation where the price of a security keeps going up, the market maker will find it increasingly difficult to get bid orders executed. Think of a situation like the GameStop phenomenon – the market maker’s bid price will continuously be too low for execution as the stock trades higher.
In a scenario where the bid isn’t executed, the market maker accumulates an increasingly significant short position, losing money. This is because the ask orders will continue to execute, on the opposite side of the trade, even while the bid misses.
The same can also be true in the opposite direction.
Clearly, these are scenarios that market makers would prefer to avoid. To do so, market volatility and order book imbalance must be taken into account.
According to a 2014 study, market makers are likely to reduce their market participation in periods of significant volatility.
The reduction in participation is driven by an increase in the spread of the market maker’s bid/ask. They will move farther into the LOB to avoid being caught out by significant and abrupt changes in the market.
This pricing adjustment by the market maker serves to reduce overall market liquidity. Reduced liquidity can make markets even choppier, potentially accentuating already turbulent conditions.
In addition to reduced trading volumes in periods of volatility, market makers will also adjust their quoting price based on movements in the order book. This strategy involves monitoring the LOB for any order imbalances.
For example, when the delta between the volume of ask quotes and bid quotes grows, market makers expect an uptrend in price movement of the security. As such, they’ll preemptively adjust their ask/bid quotes.
Conversely, they can lower their ask/bid quotes when it becomes apparent that there are more sellers than buyers.
All else equal, a market making strategy that adjusts for order book imbalances will increase returns (as well as end-of-day inventory). Adjusting the bid/ask quote for volatility in the prior strategy will also increase returns while decreasing inventory.
As such, these two strategies are often combined to achieve optimal performance.