Market Making
How a two-way quote makes money and how it loses it: what a fill earns against the mid, why the spread has to cover informed flow, how to lean the quote when inventory builds, and how much inventory the desk may carry at all.
A market maker quotes two prices at once, a bid where it buys and an offer where it sells, and tries to earn the gap between them many times a day. Almost every interview question about the job is one of four: what did that quote actually earn, why is it as wide as it is, what do you do with it when you are stuck with a position, and how big a position are you allowed to hold. Each has a small piece of arithmetic behind it, and each arithmetic has a backwards version that separates people who understand the desk from people who have read about it.
Vocabulary. The bid is where the dealer buys and the offer (or ask) is where it sells; the client does the opposite, buying at the offer and selling at the bid. The mid is halfway between. The spread is offer minus bid, quoted in cents and compared in basis points. Edge is what a trade earns against fair value. Inventory is the position the quotes have left you with, signed, long positive. Adverse selection is the tendency of the price to move against you after a fill, because some of the people trading with you know more than you do.
- Edge capture. Half the spread per fill, basis points, adverse selection and the rebate, the break-even spread, the volume a target needs, whether to match a competitor.
- Adverse selection. Bayes after a buy order, the break-even offer and spread, the informed share implied by a spread, the edge on a quote away from break-even, earnings week, why retail flow is paid for.
- Inventory skew. Cents per 10,000 shares, where the bid and offer sit, the inventory behind a colleague's quotes, the position at which the exit quote reaches fair value, what a fill does to the lean.
- Inventory risk. One-day VaR, days to exit and the square root of time, the maximum position with and without the liquidity charge, what a volatility spike forces you to sell, why halving removes two thirds of the risk.
Price the quote against fair value, never against your own cost. A fill earns half the spread against the mid; the spread must cover what informed flow costs against the mid; the skew is measured from fair value; the risk limit is in dollars of loss from here. The dealer's job is to stand a little way from fair value on both sides and get paid for the standing.
Building and running a two-way quote
The order the desk thinks in, from fair value to the risk report. Each step points to the chapter that practices it.
Chapters
What a fill actually earns
11 minA market maker quotes a spread but keeps much less than it. Each fill is worth half the spread against the mid, the price then tends to move against you, and the exchange gives a little back. What is left is the edge.
- Convert a quoted spread into basis points and into gross edge per share
- Net the half-spread against adverse selection and the maker rebate
- Find the narrowest spread that still breaks even, and the volume a P&L target needs
- Decide whether to match a competitor's tighter quote
Why the spread has to be as wide as it is
12 minA buy order is a small piece of evidence that the stock is worth more. A market maker who cannot tell informed traders from the rest must price every order as if it might be informed, and that is where the spread comes from.
- Update the odds that a stock is worth more, given that someone wants to buy it
- Derive the break-even offer, bid and spread from the informed share and the size of the news
- Read the informed share of the flow off a quoted spread
- Explain why spreads widen before earnings and why retail flow is worth paying for
Leaning the quote to get flat
11 minA market maker wants to earn the spread, not hold a position. When fills pile up on one side, move both quotes toward the side that sheds the risk: your exit quote becomes the best in the market, your entry quote the worst.
- Skew a two-way quote by a stated number of cents per 10,000 shares of inventory
- Read a desk's inventory off its quotes
- Find the position at which the exit quote reaches fair value and all the edge is gone
- Explain why skewing beats widening when you need to get flat
How much you may hold: VaR and position limits
12 minEvery share held overnight is a bet the desk did not choose. Limits are set in dollars of value at risk, and a position you cannot sell in a day is exposed for as long as it takes to sell, so risk grows faster than size.
- Compute a one-day 95% value at risk from the position, the price and the daily volatility
- Stretch it over the days an exit takes, using the square root of time
- Turn a dollar VaR limit into a maximum position, with and without the liquidity charge
- Explain why halving a large, illiquid position removes far more than half its risk