Market makers, fair value, and Knight Capital
So, I've been wondering about this for a while, but how do market makers like Knight determine fair value in equities? How do they decide where to bid-ask and how wide the spread should be? How do market makers decide where a price is cheap? Obviously this is pretty valuable information for any trader. Anyone have any experience on market making firms like Getco or Knight? How do they determine this?
I worked as a prop trader for 3 years whose focus was on short-term inefficiencies in equities and ETFs. I am currently trying to transition into fundamental-driven trades and longer time horizon trades. If anyone would like to discuss over PM, feel free. Thanks.
I am not asking for proprietary information, I just want an idea of how market makers do their job and determine fair value. If a price drops below this fair value, how much do market makers buy? How far away? How much?
I am not completely sure I understand your question, but I'll give it a shot. I am not involved in one of these firms, but I interviewed with a few, and I have friends working at quant funds/algorithmic market makers that I have spoken to about the field.
Generally, market maker firms like Knight operate at the level of split-second trades. No one is actually monitoring individual transactions. Their algorithms, unlike most quant hedge funds, do not place much, if any, weight on value metrics. In fact, their quantitative models are rarely, if ever, "smart." Instead, they are extraordinarily fast. I interviewed with Jump, an algorithmic prop trader, for a statistical analyst position. Had I gotten the position, they told me, I would have been one of very few statisticians working at the firm. Almost everyone there is a programmer devoted to maximum efficiency and speed.
These firms are not interested in fair value, or value in general. Instead, they receive what amounts to a premium for providing liquidity. Their speed protects them from most losses. They do not hold a security long enough for its value to change significantly, and their spread is big enough that in most cases it is hard for them to lose money.
A friend at a quant fund told me that algorithmic market makers do not bother calculating Sharpe ratios and other risk metrics because, short of incompetence like at Knight, they really cannot lose money. This might be part of why Knight was so unprepared for its Knightmare.
Why are you so focused on Knight? Every cash equity broker-dealer has to consider pricing, not just the 2 bit brokers
I guess because Knight is (unintentionally) famous.
They were "famous" long before that screw up.
High frequency market makers try to collect edge while avoiding adverse selection. The calculations they use are unlikely to be helpful for anything you're doing. The most common calculations are (1) based on the inside book width and posted liquidity, which "pushes" the fair value calculation to one side of the midpoint, (2) leader-lagger calculations which pushes information to the fair value calculation of correlated products when one moves, (3) volatility and total liquidity calculations which affect total size of bet and width of market.
These are all sub-millisecond routines. You wouldn't benefit from them.
If you want to see some of these calculations in action you can pull up the short term interest rate futures markets during slow hours and you'll see the sensitivity of certain algorithms when size comes in and out of products.
This is a nice big extract from a larger book on market microstructure which you might find some of these calculations and information about dealers in: http://www-bcf.usc.edu/~lharris/Trading/Book/Book-extract.pdf
Enjoy
Not that this has anything to do with anything, but on page vi in the book you linked to there is a thank you to Bernie Madoff I lol'd
hahahaha awesome
How do people come up with fair value calculations for correlated products like equities? What inputs go into that equation? Any idea?
Do long-term catalysts or overhangs enter that fair value calculation? The reason why I ask is because I'm trying to figure out the value of broker research. If broker research enters the fair value calculations of market makers, that greatly diminishes the edge in longer-term trades. I'm basically trying to figure out how efficient markets are, how market makers determine FV in day to day calculations of bid-ask, and whether or not longer term catalysts enter that calculation.
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