3 Market Making Strategies [for 2022]

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The market maker is someone who puts purchases and sells orders in the exchange simultaneously, with the hope that someone will come and fill their orders.

They are not interested in the underlying instrument prices but instead act as intermediaries between buyers and sellers.

3 Market Making Strategies
3 Market Making Strategies

Examples of the nearest real world are currency exchange tables at the airport. Their goal is to buy and sell as fast as possible, without building a large inventory in one currency.

In electronic exchanges, there are a number of market makers, all rushing -like quoting the best prices, just like you have several currency tables at the airport.

A Simple Example

You have 100 Apple shares and you want to sell them. When you click ‘Selling’ in your online broker, someone, in other places in the world, must buy the shares from you, at the right amount and price.

Opportunities to have other investors, sit at home, who order to buy exactly 100 shares of Apple at the same time low.

Market makers function as intermediaries.

A market maker will buy your shares from you, with the hope that they can reverse it for a small markup to the next investor who comes.

The difference between the purchase price and the selling price is called the spread.

Market makers are different from investors because they want to hold shares as little as possible (because there is a price risk to change), and want to trade as often as possible, to take the small spread.

For small lots, the manufacture of markets for stocks is carried out electronically.

For large stock blocks, this is traded far from the main exchange, usually by brokers who call different market makers and try to offer on the telephone.

Market makers will be a member of the exchange. This means that instead of paying fees per transaction, they will pay a fixed subscription and every free individual trade.

Market makers are needed for the functioning of the right market so that exchanges can often provide incentives to market makers at discounts, information in people, or better technology.


Read Also:


Market Makers – Limit Orders vs Market Orders

Fast Primary for Orders:

As a speculator, trader or investor, you will usually enter the market with market orders.

It was an order to trade stocks with the best market prices available at the time.

You are called a ‘taker’ when you take liquidity from the market.

You do this because you think the market is the wrong price and you are willing to bet you right.

Market makers, as a comparison, only use limits.

Limit orders to determine the right price (and only) that they want to fill.

Order limit of 10 shares at a price of $ 100 will sit waiting for the book’s exchange book order until the market order comes and takes it.

Market orders tell exchanges to fill orders at the best prices offered in the Bursa Boundary Order Book, at this time, without waiting for a better potential price.

Suitable exchange limits orders with market orders.


Strategy 1: Delta Neutral Market Making

A market maker only tries to get a small markup (spread) between the price at which they buy and sell shares, and wants to do this trade as often as possible.

A market maker, when they have bought a lot of shares, now has a direct risk, because, if prices move against them when they hold them, they will be trapped by losses.

To ward off this, market makers will try to reduce risk elsewhere.

The simplest example of this is two cryptocurrency exchanges.

Market makers will limit orders to exchanges with low liquidity, and when the order is filled, immediately send market orders (on the opposite side) to exchanges with higher liquidity.

So, if they buy at one exchange, they will sell at the other.

However, in this way, they have an open position in both exchanges, they are numbered zero, and there is no direct position (the advantage of one exchange to offset losses on the other side).

They then do the opposite to try and release their inventory.

The price that will be offered by the maker at a low liquidity exchange will be the cost of filling market orders at higher liquidity exchanges, plus a little profit.

In this way, market makers take a lot of small advantages ‘ risk-free’ every time they trade.

This is easy to do in a relatively new market with low liquidity.

Early market makers can often commit murder here by charging large fees.

Mapan/high liquidity markets tend to have a very strict spread as a comparison.

Market makers adopting this strategy look for edges by:

  • Looking for new exchanges/low liquidity exchanges
  • Make an offer with an exchange, so they get a rebate (paid) to create a market
  • Make an agreement with the exchange, so they get information or types of orders that are better than regular market participants
  • Microwave tower technology that is faster than the internet to set aside the market; For example, between Chicago and London. Have price info and orders before others produce guaranteed benefits. This is included in the category that is widely known as ‘high-frequency trading’.

Strategy 2: High-Frequency Trading – The Stoikov Market Maker

This is a different strategy, based on a paper by Stoikov, and is the basis for making a high-frequency market.

In this strategy, market makers make purchases and sell orders on both sides of the book, usually ‘at-the-touch’ (offering the best price to buy & sell throughout the exchange), which means that they will be filled every time someone comes together with the order market.

This ‘at-the-touch’ strategy is sometimes called ‘joining the spread’. Instead of having your own strategy, you effectively copy what all market makers do.

This strategy trading as often as possible, continues to fill the buying order and sell around the market price.

This strategy assumes the distribution and even buying and selling orders.

This is a simple way to say that price is a random road.

When this is the problem, the strategy of making money.

If the order becomes slanted, for example, there is a series of purchases, which you tend to get when the trend market up; Here, is the strategy of losing money.

If you sit and watch the order book on a real exchange (visit BITMEX for examples), you can see when the price moves quickly, liquidity suddenly disappears when market makers expand their spread and do protect their betting values.

This strategy has what is known as a negative slope because it produces a small amount of money most of the time and occasionally suffers losses when everything turns against it.

When market makers get content, they hope they are not (for example, in a trending market), this is called detrimental selection. Market makers try to avoid as much harmful selection as possible.

Many market makers will choose to collect inventory if they have insight (for example, if the market is trending, they might set a higher selling price).


Strategy 3: Grid Trading

This is an extension of the Stoikov strategy.

In this case, market makers limit orders throughout the book, with an increase in size, around average moving prices, and then leave it there.

The idea is that the price will ‘run’ through ‘orders throughout the day, getting a spread between purchases and sales.

When the order size gets bigger with spread, this strategy has a martingale effect – effectively functioning as a price deviant from the average price.

Unlike Stoikov, because of more orders, the filling is less common, but the spread (and therefore profit) is greater.

In this strategy, the most important thing is to calculate the average price.

The best way to do this is:

  • Average moving from price
  • Average moving from the price + leap function (the function that resets average after the surge is suddenly)
  • The best offer price at this time is regularly arranged (according to the high-frequency algorithm described above)
  • See prices on the exchange/other related instruments (sometimes called statistical arbitration)

Market Maker Myths

Market Makers Set Prices

It is true that market makers quote prices for instruments, however, in most markets, market makers compete with each other and are subject to supply and demand. In this way, they only set as many currency table prices at the airport can set prices.


Market Makers and Stop Hunting

There is an idea that market makers take action called stop hunting, where they affect the price to the point where it stops triggered and produces a stop run (many stops, which causes trends in one direction or another).

Manipulating prices in this way is not permitted in the regulated market.

Some exclusive trading market makers will carry out more aggressive strategies, but usually, this strategy involves exploiting weaknesses in the competing maker’s strategy.


Market Makers When Using Leveraged Trading Services (CFDs, Spread Betting, etc.)

Services that offer CFD and spread bets to consumers act as market makers, but only on their own platform.

In this way, you are cut off from the competitive spread that you get in real exchange.

This service imposes substantial distribution to customers (as well as funding costs).

They reduce their risks in the main market (see examples of neutral delta above), so they will generate guaranteed profits.

CFD bets and distribution are not like trading in real markets.

My back-of-Anvelope calculation itself implies that you have to make a return of 30% a year, only to compensate for trading costs with CFD. The fee for the distribution bet is still greater.

There is a CFD that is traded on the exchange, but if you are looking for a type of leverage and exposure in this equity, you will better use options, not CFD or spread bets.


Building Your Own Market Maker

Building your own market maker is a technical challenge.

The best place to start is to try and build a neutral Delta market maker (fully hedged), as explained above.

In this case, you’ll need to:

  • Find the instruments traded in two exchanges
  • Find two instruments that trade in related/cointegration (ie, they move in the estimated step with each other)

For every purchase at one instrument, you will have sales at another. This is sometimes called two-legged trade.

Choose the side with less liquidity to be the ‘maker’ side – that is, the exchange that you will give liquidity.

Bitmex has an example of a market maker written in Python, which is a good place to start.

Outside the box, this market maker carries out an ‘at the touch’ strategy (similar to those described above) – But don’t expect it to make money without work.


Frequently Asked Questions

Are there any great books about electronic market-making strategies, trading algorithms (VWAP, etc.), and HFT?

There are some books that might be useful. Some good books to try include:

  • Trade and exchange by Larry Harris
  • High-frequency trading by Irene Aldridge
  • Market maker matrix by Evan J Christopher

Does it make sense to backtest a market-making strategy?

The term ‘backtesting’ is used to describe the process of simulating strategies to identify risks or problems before applying them to real-world markets.

It is always a good idea to support whatever strategy you consider for use. This is because it will offer the opportunity to find adjustments and adjustments that need to be made and have the potential to reduce the risk of loss of money.


How can I calculate a fair price and spread for a market-making strategy?

To calculate the distribution, you must consider the purchase price and minimum and maximum sales. This will give you various prices known as spreads. To ensure that your price is fair, ideally should fall between numbers in the distribution.


What types of market-making techniques are used in the marketplace nowadays?

Some techniques can be used. They will usually be made from three core strategies:

  • High-frequency trading
  • Delta neutral market making
  • Grid trading

What are some examples of market-making strategies?

There are three main strategies that are usually used in creating market-making strategies:

  • Delta neutral market making
  • High-frequency trading
  • Grid trading

What are the best books on market-making strategies?

There are several different books to consider and each will have a slightly different attitude about how to develop the best strategy. Some of the best books to consider are:

  • Trading and Exchanges by Larry Harris
  • High-Frequency Trading by Irene Aldridge
  • The Market Makers Matrix by Evan J Christopher

What is the best programming language for market-making trading strategies?

Many traders will often prefer to use Python when they create their trading strategies. This is because it is a programming option that is widely available with a variety of packages available for data analysis purposes.

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