Every concept, endless questions
Each concept is a small financial model. Read how it works, then draw a real interview question from it: forwards, backwards or what-if, with fresh numbers and a worked solution every time.
Forward runs a concept the usual way. Inverse runs it backwards, which is what separates understanding from memorizing.
Market Making
4 conceptsEdge capture on the spread
A market maker earns the spread only in theory. Each fill is worth half the spread against the mid at that instant — but fills are not random. You get lifted just before the price goes up and hit just before it goes down, because the people trading with you sometimes know something. The average move against you after a fill is adverse selection, and it comes straight out of the half-spread. What is left, plus any exchange rebate, is the edge you actually keep. That is why a tighter spread can still make more money if it wins enough volume — and why it can also turn every fill into a loss.
Skewing a quote for inventory
A market maker wants to earn the spread, not hold a position. When fills pile up on one side, the desk leans its quotes: long inventory means moving both the bid and the offer down, so the offer becomes the most attractive in the market (buyers come to you) and the bid becomes the least attractive (sellers go elsewhere). Short inventory is the mirror image. Skewing gives up a little edge on each unwinding trade in exchange for getting flat without crossing the spread. The bigger the position, the harder the lean — until the quote on the exit side reaches fair value and the desk is paying the whole edge to get out.
Adverse selection
A market maker cannot tell an informed trader from an uninformed one, so it prices every order as if it might be informed. A buy order is a small piece of evidence that the stock is worth more, so the break-even offer is the expected value given that someone wants to buy — above the mid. The more of the flow that is informed, and the bigger the news they know about, the wider the spread must be. The uninformed pay that spread and the informed collect it: the market maker is just the conduit. That is why spreads blow out before earnings, and why retail order flow, which is almost never informed, is valuable enough for wholesalers to pay for.
Inventory risk and position limits
Every share a market maker holds overnight is a bet it did not choose to make. The desk limits that risk in dollars of value at risk, so the position it can carry shrinks when the stock is expensive, when volatility rises, or when the limit is cut. The subtler point is liquidity: a position you cannot sell in a day is exposed for as many days as it takes to sell, and that horizon itself grows with the size of the position. Risk then rises faster than size — with the power 1.5 — so halving a large, illiquid position removes much more than half its risk.