Market Making a practical approach.

What is a market-making strategy?

Market-making strategy is an automated algorithm that is used to provide liquidity, by filling up the order book with buy and sell orders, so that buyers and sellers alike, could execute their orders whenever they need to.

So market maker plays a special role in the financial ecosystem providing price discovery and building trust in the market.

From a technical point of view, market making is like arbitrage or triangular arbitrage, a high-frequency trading (HFT) strategy.

Goals of a market maker

Market makers have duties to provide liquidity, which can be understood as:

• Being present with their orders no matter the market conditions, so other participants can trade 

• Making the depth of the market (DOM)

• Making the bid-ask spread tight (competitive)

• Reduce the costs of other investors/traders to trade

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Market-making algorithm

The market-making strategies constantly quote buy and sell orders on both sides of the order book with a defined bid-ask spread. Being always present on the market creates many risks that impose many additional requirements on market-making strategies that distinguish them from other strategies:

• They are lightning-quick to react to changes in the market before other professional traders do.

• They are fully automated.

• They need to minimize the risk of adverse price movement.

  
  

Different types of marketing strategies

• Remarketing or liquidity mirroring

• Market making with or without hedge

• Spot vs futures market making – benchmarking and hedging to a futures market, like perpetual contracts for the same instrument

  
  

Features, parameters

For a market-making strategy to function in the market, it usually needs parameters that define its behavior in the market. Some basic examples of parameters include:

• Benchmark instruments

• Hedging instruments

• Quoted spread, along with minimum and maximum values

• Order size

• Order levels – how many bid and ask orders are on different price levels will be populated in the order book

• Price intervals – between order levels – another parameter defining the order ladder

• Position limit – risk management

• Minimum and maximum quoted price levels – safety checks for bad ticks or extreme volatility possible in events like large liquidations. Any safety parameters are always welcome in the market-making operations

• Maximum drawdown – another safety check defining the maximum loss that can be incurred by a strategy

  
  

What else is needed to perform market-making operations?

So we have a basic algorithm, now what about its execution? 

Software and hardware infrastructure is a big topic due to the requirements layout at the beginning of the article. Market making is a low-latency strategy. If you want to be 100% time on the market, you have to be extremely fast to not be exploited by other market participants who have information or time advantage. 

companies invest a lot in building a market-making software platform to execute algorithms, basically, an operating system, that also covers connectivity to different exchanges, and translates all the messages and events into a common format understandable to all algorithms.

for example, FIX is the protocol every market participant has agreed to use.

generally in the CFD industry when you want to do something from tech to liquidity to software or trading terminal creation you would prefer to be FIX-compliant so that everyone's life is easier.

otherwise, you would need a bridge provider, well we will discuss it in a different article but for now, I will stay on topic so that this article doesn't become an essay.

So in short, we could say that market making is mainly a software business.

Can I use ready-made market-making bots?

To play or test, yes. But for real market operations of providing liquidity?

For all the reasons explained in the last point, NO. They are too slow and too immature from a technology standpoint, and you will just slowly bleed out of capital. 

Is market making risk-free?

I wish it was. They must sell when people want to buy and prices rise. They must buy when people want to sell and prices decline. Market makers carry therefore an inventory risk. 

How do market makers make money?

Basically on the quoted spread, minus costs of hedging and adverse price moments on the inventory.

Can you beat the market maker strategy?

Yes, but rather not in a low-latency game. Market makers have to be present all the time on the market. You don’t. Market makers have duties to provide liquidity, making the depth of the market (DOM), and making the spread tight which carries some risks, as described before. If beating a market maker in the order book for some reason would be a goal, I would try to exploit these properties.

now for those who are geeks like me and want to know more about how market-making dynamic works, go and read the below books, and once done give me a summary ;)

• Market Liquidity Theory, Evidence, and Policy – Thierry Foucault, Marco Pagano, Ailsa Roell

• Option Market Making Trading and Risk Analysis for Financial and Commodity Option Markets – Allen Jan Baird

• Algorithmic Trading & DMA An introduction to direct access trading strategies – Barry Johnson

• The Man Who Solved the Market How Jim Simons Launched The Quant Revolution – Gregory Zuckerman

• Machine Learning for Algorithmic Trading Predictive models to extract signals from the market and alternative data for systematic trading strategies with Python