What do market makers do? Also, prop trading firms.
Could you guys tell me a little bit about how market making works? To my knowledge, market makers basically make money off the spread between bid and offer. So when a market maker sees a bid that is slightly above an offer, does he buy the security, actually hold it for a short period of time (a few seconds) and then sell it to the bidder?
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Can the market not operate without the market makers? That is, can’t the traders just trade securities among themselves without the spread, without going through a market maker?
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Also, do market makers have to pay commission to the brokers? If so, wouldn’t that make the spread even greater and disadvantage the traders into an even more of a negative sum game?
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I noticed that a lot of the top “proprietary trading firms” actually do market making. If market making is flow trading, why is it that these firms call themselves prop trading firms? Is it just because everything is done with their own money?
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I've also read that market making is much more legitimate than directional trading. Is that just because market making is a safer bet? If so, then why are there prop shops that do mostly directional trading?
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Excellent post..very accurate.
NG Trader what markets do you concentrate on... Are there market makers in commodities ie(NG,Wheat, Soybeans etc...)
I would figure mkts like CL to be so liquid there is no mm out there...plus alot more block trades.
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Great posts ng. Thanks
Bouncing this thread as I have the same questions...
You are sort of thinking of market making as a specific job title, but really anyone can be a market maker just by sitting on the bid and offer. In order for trading to happen you need people both willing to buy and sell. If you want to sell 100 shares of XYZ you need someone else to want to buy it. Now for a very large cap liquid stock there are tons of people trading in it all the time, so trading the shares is instant for small quantities. But lets say the stock is 100-101, and you decide to sell at no lower than 100.8, so the new market is 100 - 100.8, so basically you are market making. So a very liquid market can work without official market makers, but thats because the large liqudidity creates natural market makers. Now imagine less liquid stocks or products, you need designated market makers because there isnt enough natural flow for trading to happen.
The spread is a natural thing that happens because people want to buy and sell at various prices. Even if there are no market makers, ie in the example above, trader A wants to buy at no higher than 100, trader B wants to sell at no lower than 101, so the spread is 100-101.
Yes, we pay commission to brokers, and it does get factored into "cost of trading" when making prices, just like exchange costs etc.
Market making can be a form of prop trading, and you are correct the prop part is more to do with the idea that they are using the firms capital, and that there arent client per se as there are with IB sell side desks. As I wrote above, market making is a more general concept than a specific job title.
As written above, market making is not black and white, most market making desks run a book of risk, whether you work for a prop shop market maker or a IB client facing desk, you will be managing risk, and that is in essence prop trading.
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As an aside, what might help is a general structure for things:
I work on a single stock options desk in europe. Now the thing with options is that no one option is very liquid, because there are so many maturities and strikes. So the electronic screens on exchange even for a liquid name might only have like 100k eur notional (notional = price x number of options), now vega for 1Y atm options is approx 36 basis point of notional, so that is 360 eur of vega. So even though the screen might be 0.5 vols wide, the size is ridiculously small, which is why clients need sell side IB desks like ours, because they will want to trade 10 mil eur notional and would not be able to do tjhat on screen. Now lets say the 1Y option is 19.5 - 20 vol, as a sell side trader clients expect you to be quite close to that benchamrk, despite the size they ask ofr being 100x the screen size. So you think this vol looks quite cheap so you think its a good purchase, but whats even more important is that other traders might see it as a good purchase. So you show the client 19.5 - 20.5 vol, and he hits your bid. Now you are holding 35k of vega on this option, so you might want to reduce some, you call a broker up and request the price, and he goes out and tries to find matching interests, and this includes other IB banks, as well as the prop makret maker shops, now you might get a price of 19.5 - 21 vol in the broker market in 3 mil notional x 1 mil notional, so you were correct and traders would rather buy it. You place an offer of 20.75 in 2 mil notional. Now you can work the price and hopefully people will bid up to somewhere around 20 vol and you can sell 3-5 mil notional between 2-3 prop market makers. So you have locked in half a vol on half of the size and are left with half of the original risk, which you are happy holding as a prop trade. Now this is a very simplified scenario, in general you try to be a bit smarter, and try to see if there are any better hedges. For example lets say stock XYZ 1Y 100% options are 19-20 vol, and you see someone in the broker trying to sell the 90% strike 1Y and that is 19 - 23 vol a there are no buyers of it. Now you think that the person is willing to almost hit the bid, a client comes in for the 100% strike, now you might make the price of 18.5-19.8, sell it to the client and then hopefully buy the 90% @ less than 19.8, now you have the skew for free.
Can someone explain what market makers do? (Originally Posted: 09/04/2013)
I understand market makers constantly place limit orders to both buy and sell in all securities. But aren't the algorithms doing all that work now? What do market makers at investment banks do? Also, what if they place a bid at $90, gets filled, but market moves down? And, even if the market goes up, they don't just take profit of 1 point, do they?
I tried searching for answers to this but could not find anything that helped me fully understand. Thanks in advance for the response!
Think of a market maker as a car dealship or wholesaler. They're very good at playing both sides of the equation and may use hedging or tax strategies on stocks that may go down. Also, there are many times where they're arranging trades without holding onto them for very long: a big fund wants to buy 1MM shares of a stock at $4.50 and the market maker looks around for stock being sold at $4.46 and arranged the trade.
Market makers may also buy a stock for their own book and then sell some of their own inventory when an order comes in and the price is right, although this particular type of market making is under regulatory fire lately. Computers are good at the short term trades but currently have no way of understanding the real world and assigning value to an investment, so humans will dominate this particular sector for the foreseeable future.
....and yeah, sometimes they get shafted or make some boneheaded call and have to eat the loss
The problem is you're assuming markets are practically infinitely liquid. A hedge fund unloading a $100m HY position is a lot different than buying 10 shares of Apple on your E Trade account.
Here's a basic example:
Institutional investor wants to sell $100m in bonds which are currently selling at par. However they know that the market for that particular bond isn't deep enough to handle that all at once. So they call up their buddy at who's a bond salesman at a BB asking for a price on $100m of that bond. Note: the institutional investor doesn't say whether they want to buy or sell. Salesman calls up the trader for a price. Trade comes back with a bid/ask qoute of say .97/1.03 - the bid/ask is large to reflect that fact that $100m is large relative to the trading volume of this bond. The institutional investor decides to sell, so the trader buys it all for $97m. Now the trader doesn't want to be long $97m worth of this bond and chances are he's not even allowed to be so he hedges most or all of the position right away. Now the goal is to sell all the bonds and unwind the hedge over time and to by the end not lose over $3m (the initial "profit") in the process.
This is less the case in equities but there are still plenty of cases where an investor wants to buy or sell a significant % or a multiple of the ADTV, especially with small/mid cap stocks, in which case the same process applies.
No BB would take $100mm of a HY bond onto their book. They'd take $10mm - $20mm firm and work an order on the remainder. Typically a client might hit 4-5 dealers simultaneously though to get rid of the whole size, which of course sucks for the dealers.
Market makers post prices at which they are willing to buy/sell (bid/ask).
In cash equities and spot fx, yes, the machines are doing most of the work, I believe. In more complex products (vanilla options in large size, exotic options, credit, securitized) you still need the humans to make the prices and the spreads (between bid/ask) will be correspondingly wider.
If the market maker's bid is hit at 90 and the market moves down they lose money. If the market doesn't move and another customer comes right away and is willing to lift the offer (at >90) then the MM earns the spread rsk-free. If the market moves up, the MM earns more than the spread (depending on how long they hold the position and how much the price goes up).
Where the value add (which is what I think you're asking) comes from is that market makers will skew their bid/ask prices up/down around the midpoint depending on whether they want to get longer or shorter in their book, and will also widen/tighten the bid/ask spreads depending on the uncertainty in the market. They need to have a view on the markets to do that. They are dealers (hence the "dealer" part of broker-dealer) who take on principal risk in order to provide liquidity to their clients.
Market Making (Originally Posted: 05/20/2011)
I found that many prop trading groups and hedge funds have market making strategies for listed securities (equities, option, commodities, etc). It seems that these firms still recruit trading analysts with financial backgrounds to run those desks. I don't see how all of these firms did not fully transition into only recruiting programming professionals. Given how fast markets move - difficult to fathom how a human could keep up. Any insight?
Brady4MVP would be the perfect guy to answer this, but I can start from the programming side. There is absolutely a lot of stuff computers can do today that they couldn't do fifteen years ago in market making- not just mechanical responses to trades but actually operating as a guided learning decision engine. That said, there's a great deal of insight and analysis that goes on that a computer can't perform. Research engines like Watson are starting to change this a little, but not a whole lot. A human being is still worth more for making these decisions than a supercomputer, but that could change in 20 years.
How much has this changed since 2012????
Trading is more than just trading stock - this is an information business. As IlliniProg mentioned, computers can't yet trade information and add insight.
Help a noob - what's a market maker? (Originally Posted: 04/15/2011)
Hello,
I'm just trying to get a better picture of the trading world so bear with me here. I know a market maker is required buy/sell an asset at the best market price and they make money on the bid/ask spread.
So what are some other attributes of a market making firm? Let's assume a firm ONLY does market making. -Do market makers even care about fundamental analysis or charting? I mean if their goal is to close a position as quickly as possible and take advantage of a spread, what's the point of knowing the intrinsic value of an asset or looking at past 'chart' performance? Shouldn't they only care about the current volume and the number of bids/asks at the different prices? -Wouldn't game theory be more important than fundamental or technical analysis?
Also, since market makers make their profit on the tiny spread between bid/ask prices, that means they must be a type of high frequency trading firm correct? That is, a market making firm is a type of high frequency trading firm, but high frequency firms also include arbitragers and prop shops that mainly use technical analysis (for example those that day trade euro/dollar futures).
Finally, what are the main ways a market maker makes money? Obviously from the bid/ask spread and a rebate they gain from the exchange through accepting bids and offers. Do they make money from anything else?
I know the business model of each trading firm is different, but let's just assume a firm only does market making.
Thanks.
By the way, what is a high frequency trading firm anyways? Is it any firm that day trades? Is there threshold as to how many positions they need to open and close in a day that suddenly makes them a high frequency trading firm?
you do care about direction, if you you are a market maker at a bank chances are you will be hit with positions that are large portions of daily volume, and can't unload that.
There is a whole spectrum of products in terms of large vs small spreads largely depending on the liquidity of the product.
HFT firms basically trade in nanoseconds.
Yes HFT is algorithmic trading. It takes human error out of the equation.
okay okay, in THEORY that's what it is. Please, explain it better in one sentence or less.
market making = people that are incentivised by the market (and the search for profits based on statistical models)
hft is trading at high frequency, making smaller profits per transaction but making money on volume (and reduced costs because of higher volume). Computers transact based on programmes, most common issues are technical, while human risk is removed, if a computer doesnt have a decimal in the right place you'll lose your company.
Wow, if you don't know the answer to a question, you shouldn't post^^. Any participant in the market is incentivised by the market--That is why they are there in the first place. Do you honestly think Toyota would give a shit about Dollar-Yen if it wasn't incentivised to do so.
Back to OP questions, Their are two key types of traders, market makers and prop traders. A market maker is a sell side trader that deals with clients, they work at banks or small brokerage houses. The other type of trader is a prop trader or a buy side trader, which doesn't deal with clients and traders to make money and/or manage his firm's risk. Buy side traders can be found in banks, hedge funds, asset management firms,ect. A broker while technically not a trader is a liquidity provider and is on the sell side. A buy side trader uses brokers and sell side traders to make trades.
HFT are not market makers.
Yes market makers care about fundamental analysis and they do not only make money from the spread. Where do you think these securities come from, the trader's ass? Every market maker has a book (aka inventory) that they manage and is essential for providing liquidity. Market makers make money off the positioning of their book. A trader doesn't buy a security and immediately sell it. First, that is no one to make money and second there is not enough liquidity in most markets for that to happen in bulk--the buck has to stop somewhere and someone needs to take on the exposure/risk.
In terms of making money off of the spread, there are two instances where this happens. One is the trader is talking with one client over BB who wants to sell and another client over BB who wants to buy. He will work the one who wants to sell to a lower price and the one who wants to buy to a higher price. Eventually he will close both, buy the securities and immediately sell them to the other client and probably make a nice 3 or 4 ticks for himself (we are talking bonds and OTC products not exchange traded equities, just in case you didn't know).
The other way a market maker makes money (this is a fixed income/debt example) is when the client wants some bonds that are on someone's BWIC (bids wanted in competition). The client will either tell the market maker what to bid or he will ask the market maker to bid for him. If the market maker wins the bonds, he will give them to the client for 1/2 a tick to 1 tick more than he paid for them.
Back to book positioning, the trader has a book of securities and he needs to decide which securities he wants, which he doesn't, and how best to hedge the book. While it is not "prop", every trader deals with a "prop" component. Maybe he thinks that TM is under priced and will see some strong client demand, the trader will buy lots of TM shares. Is it to provide liquidity, yes, but a market maker manages his inventory with his own view of the market and is taking a "prop" position. I know of one bank back during the Summer that thought the Euro crisis was overblown and started buying lots of calls and Euro/Dollar in the FX market. Did they make a shit load of money when the Euro rallied--yes, but they were also able to provide the best liquidity/prices to clients who wanted to get long/cover their shorts because they had the Euros and options to sell.
A trader may also be given a position from his market making activities that he doesn't like-lots of client selling it, he doesn't like it himself, but there aren't any buyers so he is stuck with it. If he doesn't like it, he can go into the derivatives market and hedge out the risk while still keeping the securities in his inventory.
Also, every trader has general "book hedge" If you trade credit, you have CDX index shorts (along with SN CDS). The size of those shorts changes based on the size of your book and where you think spreads are going. If you are bullish on credit spreads you will remove some of the CDX short. If you are an equities trader, you will have a general S&P short which will change.
Market making isn't about making money off of the spread, it is about providing liquidity to the market by constantly giving bids and offers and being a main point where buyers and sellers go to exchange. A market maker makes money from the general market movements and his exposure to those moves.
Thanks Gekko for the response, helps out a lot. I still have a few questions though...it's hard to know what the industry is like without actually working in it.
1) The relationship between market makers and banks are anonymous right? Market makers don't get to know who they are dealing with and the size of the orders right? That seems pretty unfair if they do. So when a bank puts in an order, does the order go to the exchange first and then the exchange contacts its marketmakers or do the banks contact the market makers first.
2) You say market making isn't high frequency trading but wikipedia says it is. I guess to clear things up, is HFT just using algorithms, black boxes, and grey boxes to trade? Or is HFT defined by how quickly you open and close a position and the volume you do in a day?
Show me the wiki page. It probably means HFT as in adverb adverb noun rather than the proper noun "HFT". HFT the proper noun uses algos and programming.
A market maker is the trader and works at the bank/brokerage. You are thinking of a specialist on an exchange (see wiki http://en.wikipedia.org/wiki/New_York_Stock_Exchange#Trading in the trading section)
The vast majority of products are traded OTC and the banks know who they are trading with. That is one of the jobs of the market maker--to help clients get in and out of positions with minimal market impact. When a trader quotes a bid or an offer, that is the bid or the offer that he is personally willing to buy and sell at. He may have a client on the other side which helped influence his price levels or he may simple take it down for his inventory and maybe get rid of it later if their is client interest. A person that is looking to trade a product isn't going to one bank. They are talking to several brokers and banks who in turn talk to each other or other banks/brokers. Each bank/broker that the client went to will quote a price--the client will naturally choose the best price that he has been quotes (or he may decide not to trade based on the levels he has been given).
To give an example, over the summer a large macro fund bought a 800MM notional call on Pound-Dollar with an extremely short tenor (maturity) (I don't want to give too much away). One bank took it all down, but they didn't want all the risk so they asked for quotes from other banks on the same call option only with smaller notionals--say a few 100MM and 150MM notional options. The banks that the client went to for prices in addition to bank that eventually took it all down all gave crappy levels to the bank that was trying to hedge the risk because they knew that the fund had bought the option. Banks that didn't know that about the macro fund gave better levels to the bank that wanted to hedge out the risk. The bank was able to hedge out some of the risk, but ultimately kept some of it. Because of the large size the macro fund had made the entire street really short that currency pair and liquidity in pound-dollar options dried up for a few days while the street worked the exposure out of its system.
SB to you Gekko, nice of you to take the time to explain
Thanks for the response again.
Ok, that clears some things up. I was thinking about a specialist on an exchange and not the market maker at banks you talk about.
Just to make sure I completely understand, firms like Getco or Tibra are exchange specialists (although, since their business models are unknown, they could very well also act as market makers in OTC markets).
very nice post
Just FYI you don't call out in more than 100 GBP in cable options, standard practice ;-)
Gekko stop badmouthing equities... it bothers me hahahaha
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