How Do Liquidity Providers Hedge Their Risk?

Discussion in 'Trading' started by jz3384, Mar 8, 2009.

  1. jz3384


    I am wondering how do liquidity providing traders hedge their risk? Let's us they post both a bid and/or ask, and the bid gets hit. Now what if the stock price keeps going down? Is he not losing money now? How does he manage this directional risk? If he does fully hedge when his bid is hit, then by definition he can not make a profit since he is now fully hedged and not to mention he will be losing the bid-ask spread by using a market order to hedge. Appreciate any insights into this.
  2. Usually marketmakers have 100s of stocks that they make a market in. So their Event risk is never too high and their Market risk is hedged with futures.

    Then their is the option writing/buying component to this- buying OTM options and selling ATM... or viceversa. Long puts but hedging with the stock...

    Susquenhanna, Knight, Citadel all likely do this each day.

    - Just a guess though -
  3. jz3384


    1. I don't think having 100s of stocks help since vast majority of stocks are highly correlated and move with the market. Most stocks are down by more than 60% as the market did and these liquidity providers have to hedge somehow as their bids are constantly getting hit, otherwise they would be losing a lot of money.

    2. How is it possible to dynamically hedge in the options market? I mean your exposure constantly changes throughout the day as your bid/ask is getting hit. Consider the bid/ask spread in the options market, you will just get killed constantly buying/selling options.

    3. You mean they hedge with ES or SPY? This would only work if the volatility of the instrument they are providing liquidity with is greater than the hedging instrument, you will lose money otherwise. And even then, you will lose money if the market keeps going in the same direction as the recent market has done.

    I still don't see how liquidity providers effectively hedge their risk.
  4. They (the Market Maker) gets hit at the bid and price keeps going lower - a) they simply dump their position, and more - to the next possible bidder(s).....and/or b) they ramp the price higher, or simply sell at a higher price (.01 or more), repeat as necessary.

    As for options, that's easy - they simply buy or short the underlying as necessary at the same time the option's transaction takes place.

  5. If you look at the financial statements of say knight trading, You'll notice they have an inventory of stock almost 50/50 long/short. They are left to make the spread I suppose.
  6. jz3384



    You say if the bid gets hit, and the liquidity provider will try to sell at higher price, but what if the price keeps going down (i.e. his bid repeatedly gets hit)? How would dumping his position to the next high bidder help? Wouldn't the liquidity provider lose money? I mean usually the price will penetrate the bid and keep going for a few cents or more. If the liquidity provider constantly dumps his position to the next high bidder wouldn't he be constantly "stopped out" and thus losing money?

    As for options I was asking the question how is it possible for a liquidity provider in a stock to dynamically hedge his stock exposure in options since the bid/ask spread is usually wider in options.
  7. jsmooth


    If you're an Options Market Maker.....and you think the option is worth 50 cents (after doing your calculations with the black scholes or binomial model), you'll be bidding 40 at 60, then once you get hit, hedge with the underlying contract. After hedging (and re-adjusting your hedge each day), you'll make that 10 cents profit risk free. Over the long term, if your volatility calculations are close to correct (and you are receiving the order flow), your going to be making those spreads over the long term.

    If you’re a Local that takes on paper your essentially doing the same thing. If GS wants to buy 100 contracts (and you're a market maker), GS will come too you to make them a market. If the supply is there, you'll be on the offer 100 contracts and they'll hit you, you'll then try to push the market lower and find a paper buyer to re-sell those 100 contracts into. Going back; lets say GS wants to buy those 100 contracts, but your also bullish the market, obviously, your not going to take on that trade, you'll front run him and instead bid the market up, and force that paper buyer to pay up.

    if your a Market Maker, your job is to essentially find paper, and let them into the market. But when you let them into the market your going to make them "payup", give up their edge and pay the spread. Your basically like a ticket scalper that you see outside some concert. Your holding a card board sign that says "I need Tickets"...when you find some guy that’s got 2 extra tickets, you get him to sell em too you for 50% of Face Value, then you immediately try and find the guy that wants to goto the show but doesn’t have tickets yet...then when you find him, you make him pay up. You make that spread by taking on risk and acting as the middle man between those two people. If you can do this over and over each day, you'll hit a lot of singles and make a nice living.

    Hedge Funds....same concept, just different instruments...

    Get these books:
  8. jz3384



    I was asking the question of how can liquidity provider in stocks hedge their exposure in options since the bid/ask spread in options would just kill you, not the other way around. I understand your analogy of the ticket scapler that tries to buy a ticket and immediately resell that ticket for a higher price. But my question is what if the ticket price keeps going down as he buys more and more tickets? How does he hedge this risk?
  9. jsmooth


    You're failing to take into account that Market Makers <b>wont</B> post a bid or offer unless they believe that their bid/offer is a competitive one and if they get hit on that bid they will be buying at a discount (or selling at a premium). If you're a market maker, the whole idea is your trying to find someone (paper) who is willing to <u>give up their edge </U> in order to get into the trade. if you're a stock market maker your going to take into account the spread on the options before you even post your bid/offer....lets say you post a market for a stock, then get run over, if you want to hedge your exposure with options, you'll have to give up your edge to the options market maker (otherwise you run the risk of posting a market on the options, not getting filled, and getting hurt some more on your underlying position). If your a stock MM, the easiest and simplist strategy is see a 10k bid at 40cents, you start bidding 42 cents....if you get hit and the market still keeps falling and doesnt go bid at 42 or 43 cents, you can just stop yourself out against the 10k bidder at 40....

    If you make a market, take on a position, the market keeps going against cant hedge or find someone to take the other side and liquidate your position = a Short Squeeze

    Fridays Rally into the last 20 minutes was just that....Locals sold a bunch to Paper, the market never turned and they got squeezed out into the close and pushed the market up like 5-7 handles doing so
  10. jz3384


    With a stock, how do you buy at a discount? I mean for a stock, its price is determined by the market, it's not like an ETF where you can instantly calculate its net asset value and post a bid that's below the NAV. A stock is only worth what market participants are willing to pay for. So I don't see how a liquidity provider can try to buy a stock at "a discount". Using your example, if a liquidity provider posts a bid at 42 cents and it got hit, you are saying he should stop himself out at 40 cents if he can't sell it for 45 cents. I just don't see how this could work! The distance from 42 cents to 45 cents is 3 cents, the distance from 42 cents to 40 cents is 2 cents, therefore the probability of market moving to 40 cents is greater than it moving to 45 cents. You would get constantly stopped out if you try this.
    #10     Mar 8, 2009