Just as the header says, I would appreciate a bit more detailed information about how Props shops(especially MarketMakers like Optiver,JS, Virtu, etc) make money.
Basically what I thought was that the Profit model of the industry is quite simple: they provide the quote of the bid-ask price, and when the trades are conducted, they make money through these spread.
According to the website from those MMs, there are terms like Institutional Trader, Sales-Trader, Wholesale trader where the job description says they handle with the institutional clients to execute their trade orders.
I thought this sounds quite the similar way as typical Equity Sales Trader in the IB. But doesn't the term Proprietary mean that they don't get the external funding or investments from the buy side clients? If that is true, I'm not sure what makes a difference btw IB and Prop shops when dealing with the Institutional clients that they face(I'm not even sure whether Props do manage relationship with Institutional clients)
I would appreciate if someone could kindly explain the overall process before actual trading happens(ex: beginning from the issuance of the products?) and how each process is related to profit generation of Prop Shops.
Thanks in advance!
I can comment a bit on the options market-making side of things since that's what I'm most interested in and where my experience is. Additionally, I'll comment more from the OTC side of things and as a disclaimer, we do not need to immediately go delta neutral to hedge.
I'm on a very OTC-focused desk so we only trade size (order minimums) and it's also a lot easier to understand from a P/L perspective here. Someone sends a request for quote (RFQ) for like 10M notional of let's say BTC options through an electronic liquidity-providing aggregator (Paradigm).
Let's say they're wanting a two-way market on 200 50K BTC calls expiring in June. (Current screen quote is 0.0860 - 0.0880: it's in BTC so convert to dollars if you want to see dollars).
Let's say since this is a 10M order and the current size offering is 19.3 bid 13.7 ask and he wants to buy 200, it makes sense right now if I have no position to make a bit of a wider two-way market (if I had an axe - or a specific position I wanted to put on I could skew that way to incentivize them to sell or buy from me).
Ok now that I've established I can quote a bit wider here since he wants a market of 200 options to buy/sell and the current size won't fill in a single order on the exchange, I'll price my spread at 0.082 - 0.094 or something (this is an example and this is pretty wide for a MM but let's just go with it). Let's say he buys from me at 0.094 so now I'm short 200 BTC 50K calls and was paid 0.094 each for them and I could go on exchange and buy them back for 0.088 and profit the 0.06 from immediately trying to buy back on exchange. All of that is profit, but as we know from the screens I could maybe only do that for 13.7 lots and still have 186.3 lots of contracts that I'd now not be able to offload for the 0.088. Maybe this is when I decide ok, I'm done offloading risk on the exchange for a profit, let's turn this into a short vol trade and go delta neutral.
I look at the 50K calls of 0.46 delta that I'm short now and see I'm short 92 delta worth of BTC (let's just assume I'm back at 200 and not 186.3), I go to the same exchange and buy 92 perpetual futures of BTC and now I tell myself I'm done on exchange and I'm just going to actively manage the position and treat it as a short volatility trade, so as volatility declines I will be making a profit on the options losing innate value (if I'm short 50K calls at 0.094 and price stays the same but theta passes and volatility declines I'm going to be making money if I hold to expiry).
Also since this was OTC and it was 10M notional let's just say I also took down maybe 10 bps of commission for executing this trade (it's crypto, not fx so we'll just say 10bps). So after this trade, I took down 10K in commission, 13.7 * 0.06 * BTC Price from just making a quick trade on the exchange after going short a bunch of calls, and now I have a delta-neutral position that I'll keep in my book and manage till expiry. I'll keep making small delta adjustments when I feel like it but managing a book of options and being a vol trader is highly discretionary in nature, you're just supported by some great systems for curve fitting and volatility analysis. Like now that I know I have some delta neutralized options position, it doesn't mean I leave it be and then I go do whatever I want. If volatility increases for an OTM call, deltas start trending towards 0.50 so now if I'm short 92 delta and volatility increases while prices stay the same, I need to short more perps to stay "delta neutral".
Disclaimer I'm a 1st-year options trader and there are people much smarter than me but TLDR that "spread" isn't guaranteed profit it's like a theoretical profit until you actually unwind the position and realize the spread difference. I see what you're saying by the spread. Ideally, a MM will know an exact price where someone will buy and someone will sell and that's the spread, but typically these trades don't execute immediately and you're left holding a bag that needs to be managed.
That's just a single trade, now let's say since I'm a market maker I have an obligation to be making tight markets to tons of people for any sort of product. Now let's say I'm short June 50K calls, Long May 40K puts, short a July/Dec Calendar, and you quickly realize no matter how delta neutral it looks one wild swing in volatility, one unexpected change in spot, one oversized trade in a certain expiry, can all completely change your risk.
I didn't expected this kind of extremely elaborated explanation:) Made me understand about the process in more detailed way. Thanks a lot!
No problem, honestly it’s a very opaque kind of career path and you only experience this from an actual internship at a market maker/S&T firm when you have the ability to directly ask questions. Always happy to help new students and experienced candidates learn more about a very fun and exciting career. Options MM is my favorite because of the previous reasons I listed. I have a book of dozens of strikes/expiries on BTC/ETH that I have discretionary ability to manage each day based on my ideas with support by our systems. If I think we’ve oversold vols I might be axed to pick up some calls/puts. Or if I’m looking at historical and current values for skew and term structure and see a weird upward kink in the June expiry for ATM I might be axed to sell some of those as volatility tends to mean revert and this adds to my edge. Or if I think the market is overly bearish right now and there’s a 16 point spread between 25 D calls and puts (skew) I might sell some risk reversals (sell out buy call) and over the course of the trade stay delta neutral and wait until the call IVs start trending higher so I profit on the call IV rise and put IV decline as sentiment shifts. But that’s only a single position maybe I need to also manage my calendars in the later dates too. Being an options MM is really all about trading volatility while being aware that you can also take slight directional views from a risk perspective because you don’t need to fully hedge things out. Very fun, very fast paced, very lucrative.
This is very interesting cuz this is exactly what a flow vol desk is doing at banks/traditional space. Who are the leading players right now in the crypto vol space?
That’s because prop MMs and S&T divisions are in the same business. Not sure why people think they aren’t. The main difference is how sophisticated the systems and technology are.
Only reason there’s such a big early comp difference is because these prop MMs have lower overheads so can afford to dole out $$$$s to inexperienced folks.
Crypto Vol would be Genesis, GSR, DRW, Akuna, LedgerPrime. Most of the big people who say they’re in crypto like Jane, Jump, Tower, Dexterity and Wintermute are doing HFT/Algo arbs on DeFi and cefi. Wintermute is actively building out crypto options right now though.
This is great. SB’d
It’s pretty much a mix of:
- Bid-Offer Quote Spread
- Trade Execution Commissions
- Managing Inventory + Hedging P&L
Lol I think these are pretty much the rough summary of how they make money:) Yeah I think I had a strange stereotype that IBs and MMs Business model is quite distinct. thanks for the reply!
You got a broad understanding of the business. I hope to help by elaborating on the specifics.
The business model of MM Prop shops and IBs are the SAME. Both of them like you said, generate profit by capturing the spread. The difference is how each entity is capitalised.
To conduct this business, the entity needs to set up trading channels on trading venues. A good example are called MDPs ( multi-dealer platform ) on which you'll have a client, say a HF, looking at the bid / offers streamed in by said entity. The difference between MM Prop and IBs are HOW credit lines are established to make these trading channels a reality.
MM Prop shop, credit is backed up by founders capital. IBs, credit is backed up by the bank's balance sheet
Next, within the prop shop, MM and Sales-Trader perform TWO different roles. MM takes on principal risk, trader is given a decision on when and how to unwind. By taking risk, you make profits from the spread. For the Sales-Trader, they are agency, they don't take risk. Their function is to perform best execution practices for the client and they make money from commission. In fact, the Sales-Trader is a price taker, a price quoted by the MM. Their value add, relative to competitors, is executing a trade for a client with lowest slippage, minimum market impact and / or better than TWAP fill
So MM and Sales-Trader are really in separate businesses. I believe in most places, MMs don't interact with clients directly. Their 'interaction' with clients and the market is via the PRICE THEY SHOW. Sales-Trader take the PRICE and attempt to 1) get client to trade on that price and 2) provide advice on when to trade on what price to give optimal execution for the client
The thread so far only talks about the mechanism of a market market and how theoretically it makes commission. I.e., Making a market and providing liquidity by taking the opposite side with the hopes of having the inventory to close out the position or having some sort of bet that the position you now have incurred can go your way. I can think of three reason why this doesn't scale;
The reason market makers such as Citadel, Virtu, XTX, etc. (at least in the equities space) make commission and continue to generate is because of bi-lateral agreements or payment for order flow. In other words, dumb money comes to Citadel they are able to internalize these order without trading it in the marketplace. If they have liquidity exhaust, then they can show this the marketplace.
Long story short, i think its equally important to understand the business model and not only the mechanism at play. "Who" you are marking a market for? is it dumb money? or institutional funds?
Just 2 cents btw.
Thanks for the explanation! I really appreciate that you focused on the business model instead of the mechanism. About the reply,
"In other words, dumb money comes to Citadel they are able to internalize these order without trading it in the marketplace. If they have liquidity exhaust, then they can show this the marketplace. "
-> Could you explain a bit more about this part if you don't mind?
Yup, super simple example. stock ABC with the nbbo as 10x12. Person 1 wants to buy ABC at market. Person 2 wants to sell ABC at market. Both Person 1 and Person 2 come to me at the same time.
As a market maker, i can cross and internalize these orders and make money on the spread. So as a market maker, you make a $2 spread.
If for some reason, either person 1 or 2 missing, then as a market maker, i need to trade this in the somewhere else (liquidity exhaust). Which is not ideal.
So to complete the picture regarding the relationship between broker and market makers and payment for order flow … Market makers pay brokers for their flow and then in turn, market makers can cross this flow and make money on the spread.
So real life example - robinhood (broker) and citadel (market makers). Robinhood orders and people who use this platform tend to be simple orders (i.e., not institutional “smart” money). This is a great for Citadel, since its flow they can cross easily and internalize and capture spread. So citadel pays for robinhood for flow, and citadel crosses this flow and captures the spread. And Robinhood gets away with having a platform that has like 0 cost to run it.
Setting Bid-Ask spreads and drawing in marginal profits this way. Market-making is also fueled by relationships in the industry, while profit may not be the primary motive here, setting liquidity in the marketplace for clients will encourage them to do business with you. For example, you work on the FX desk and Apple has operations in say Mexico. They wanna lock the rates in advance to convert the pesos to the USD so won't lose money on a poor rate later on.
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