Global Financial Market has witnessed a seismic change over the last two-three decades. Rapid advancement in technology, increase in the number of trading venues, increased market participation and high trading volumes, have all made markets little more complex than before.
Edward Leshik and Jane Cralle, the authors of the book, “An Introduction to Algorithmic Trading” have put down this complexity in the following words, “In order of complexity the Markets rank a good 4th after the Cosmos, Human Brain, and Human Immune System.”
Market participants play an important role in today’s ever-changing markets. A key market participant in an exchange’s trading structure is the Market Maker. This article covers the Who, What and How of Market Making and an introduction to high frequency trading strategies.
Introduction to Market Makers – Who are they?
Market makers are agents who stand ready to buy and sell securities in the financial markets. The rest of the market participants are therefore always guaranteed counterparty for their transactions.
Market makers are known by different names. On the London Stock Exchange, market makers are called jobbers, while on the New York Stock Exchange they are now known as Designated Market Makers (formerly known as ‘specialists’). Find below the names of DMMs on the NYSE.
Market Makers operate in the markets for the following instruments:
- Exchange-traded products (ETPs)
Traditional market makers are usually under contractual arrangements with the stock exchange and are incentivized to achieve benchmark quoting requirements. High frequency traders can also act as market makers and play a vital part in the overall ecosystem.
Market makers can choose to have the following quoting benchmarks:
- make a market on a continuous basis
- make a market in response to quote requests
- make a market both on a continuous basis and in response to quote requests
How do they earn profits?
Market Makers profit by charging higher offer prices than bid prices. The difference is called the ‘spread’. The spread compensates the market makers for the risk inherited in such trades. The risk is the price movement against the market makers trading position.
The market maker may purchase 1000 shares of IBM for $100 each (the ask price) and then offer to sell them to a buyer at $100.05 (the bid price). The difference between the ask and bid price is only $.05, but by trading millions of shares a day, he manages to pocket a significant chunk of change to offset his risk.
Risks in Market Making
As mentioned above, the primary risk a Market Maker can face is a decline in the value of a security after it has been purchased from a seller and before it’s sold to a buyer.
Market Makers are always counterparties to trades done by informed traders and in case of any volatility in the market; the Market Makers are often stuck with wrong positions.
Another fatal risk for a Market Maker is to not have the latest information. The Market Makers can survive by managing risks only if it is possible for them to receive & respond to information quickly.
Strong markets need Market Makers and to have Market Makers it should be possible for them to survive & succeed without big losses.