There appears to be sparse books about market making and specialists. Any recommendations? I am not looking to be a market maker. However, I would like to know about market making for the sake of knowing more about market behavior and influence --really, just the basic market mechanics that are overlooked. Any markets will do. While I am at it, I doubt there are many books about market manipulation since this is usually a hush-hush topic, are there any kind of introductory material/report about this zany behavior without the conspiracy nuttery?
I make markets in options. I can't speak for other markets, ie. forex, but despite what people say, there really aren't any techniques we use to 'rip off' the retail trader. Market making systems are generally very advanced such that the theoretical prices they quote around are as accurate as possible at any given point in time. This is essential and the main difference to a retail trader who aren't required to be in the market at all times. We set bid/ask spreads around our calculated theoretical prices that we observe in the market at each strike. Generally, these spreads are as tight as possible, given the competition in the market, but these spreads must still be wide enough where we can still make a profit. The prices we set are responsive to supply and demand in the market. If institutions are sending through large orders on particular strikes, than prices will adjust around such orders as a market makers goal is to remain flat and set their prices such that their is equal demand on the bid and the ask. Spreads will widen around figures and sudden movements in the market, we don't give away options for free. Market makers generally operate under the assumption of the efficient market hypothesis, that the best prediction of a price at any point in time is the current price, that is how we make our money. If conditions drastically change such that this is no longer true in the short term, ie. prices are clearly heading down and vols are heading up in a crash, liquidity and spreads will change to reflect that, to the point that we will pull out of the market if movement is particularly fierce. That is about the crux of it. A good market making firm will also employ arbitrage in their operations given their advantage in being so close to the order flow, but as far as pure market making goes, it really doesn't get much more complicated than that.
what do you do then the price is going in one direction? how do you know how much to bias your quotes?
I think he is referring to what I said about how we'd change our quoting behaviour when prices start heading in one direction. I wasn't specific enough, I meant when a shock enters the market, quotes will widen significantly or be pulled while we reassess what the news means, and then the quotes will be kept wider than before to account for the increased volatility. The main risk a market maker faces is from sudden shocks where traders can hit us at prices that are bad for us, ie. at prices that were fair before the shock and the future price has moved away such that we miss the hedge. Generally if markets are heading down, the vols will be jammed up (leading to higher option prices), particularly on the downside. This is done to account for the increase in buying pressure. But despite the wider spreads, we generally don't quote any differently because we can always hedge (ie. we keep quoting around the fair price, we don't bias anything as if we were to expect further down movement in the future). These times are often when we are making the most money because of the higher credit we get from the bid/ask spread.
I read Lukeman's book when it came out, and found it pretty good at it's time. Today it's probably not that special or relevant but I would say it gives some insight into the processes a market maker (in stocks) go through.
yes, i was referring to how you change your quoting behavior. how do you hedge exactly without eating into profits? on a per contract basis, your profit is the spread, so it doesn't seem like your hedging cost can be too high.