ChkitOut, Interesting observation. I wonder how they constantly keep an inventory of stock 50/50 long/short. Let's say you start out with 100 shares of XYZ stock long and 100 shares of XYZ stock short and stock XYZ currently trades at $100 per share and you begin to provide liquidity. Lets also assume that you put 1 share on the ask at 101, 102, 103, etc... If the stock moves to $130 a share, your asks would be getting hit and you end up with 70 shares long at $130 and you would be making money on your long inventory. However, you just lost $3000 ($30*100) on your short side, and you've only made a little more than 70*$30+sum($1, $30) = $2565 on your long side. Overall, you still lost money. I don't see how they can keep a 50/50 long short profile, provide liquidity, and still make money.
If the price keeps moving against him then he dumps his stocks and tries again. He's hoping for more changes in direction but can't prevent all losses.
I had this exact same question and posted a question about how the liquidity provider GETCO (use the search feature) makes its money. Someone answered, and I pieced the system together. There are papers written about this that are freely available on the web. Read that thread!! I've always subscribed to the theory that the greater the first-order (lag 1) auto-correlation [for small time-scale returns] is on a normalized time-scale, the more likely the MM is recovering the spread. This is mentioned loosely in the book "An Introduction to High Frequency Finance", by Olsen I think. (Chapter 5.) So in other words, if there's a spread of 5 cents, e.g., 1.35 x 1.40, and the stock's real fair price is 1.375, the MM can quote at 1.35. If he gets hit, he can temporarily come back in at 1.37 or 1.38 and collect a spread. MM will always quote at a level that envelopes the theoretical-value [perhaps constructed with intraday factor models, or relative valuation, or what have you]. If he doesn't get hit at 1.37, he can remove liquidity at a loss back on the bad -- he cannot hedge with options because the option spread is going to be too wide. He -can- hedge with a synthesized portfolio of other stocks [stat-arb technique]; however, note that the MM is betting that the opportunity to collect the spread is statistically more likely than not collecting the spread. MMs can create an effective "guess" as to what his expected value for his trade. Let's use a simple model, where the spread collected is a fixed constant and the loss-cutting is also a fixed constant, instead of random variables themselves: Let X have two outcomes: A: collecting the spread, or B: cutting losses. Let alpha = profit from collecting spread Let beta = loss from cutting losses [Note, alpha and beta are just arbitrary constants here and do not have their usual meaning when referring to stocks] E[X] = alpha * p( A ) + beta * p( B ) if( E[X] - transaction costs > 0 ), the MM is going to play this game all day long. The real world doesn't have a fixed alpha or beta in that above expectation. The MM probably has proprietary algorithms to estimate those parameters so he can make profits in the markets that he wants to make profits on. I suggest you record the level-2 depth and level-2 quote for a day, homogenize the time-series, and go back and analyze the individual transactions -- then assign guesses to when MMs were involved. It's enlightening.
Usually you don't hedge it. You are being paid the bid/offer spread to take the directional risk until you can exit. In any case, for most financial assets there is no pure hedge. If you try to offset, usually you are just adding basis/spread risk to your already existing directional risk. The best way to minimise the risk is through market feel, knowing when it's more likely to be a big order or one-way move, only taking risk when the odds favour you, and keeping your size down.
To use a simplistic example, let's say a stock is trading $10 bid for 1 million shares, $11 offered for 1 million, and the stock trades at an average price of $10.50 during the day. A market maker can go bid $10.01 for 10,000. If he gets filled, he will then offer out at $10.99 (or maybe lower if he wants a quick fill) to get flat again. If he gets filled, he makes 99 cents times 10,000 shares, or $9900. Assuming a roughly balanced market between buyers and sellers, by the end of the day he will have bought at 10.01 and sold at 10.99 numerous times and make a big profit. If supply starts overwhelming demand, and the $10 bid starts trading out, he can usually exit his position once the $10 bid gets down to the last 100k shares or so. He will just turn around and whack the $10 bid, and lose $100. $9900 if the market stays flat or goes up, $100 loss if it goes down, that's nice odds. Of course it's not quite this simple but that is the general principle. The average price is higher than the bid and lower than the ask, so with a directionless market a liquidity provider will on average earn the bid/ask spread per trade. Given some directionality, this will eat into the liquidity providers profits, but usually not enough to eat up all the bid/ask spread. If the direction is strong/obvious enough, then the liquidity provider will bias his trades e.g. if there is powerful buying, he will only go on the bid and will carry some long inventory, and only offer out his longs to get flat - no net shorts until the strong buying dries up.
Ok, I see what you're saying now. I'm pretty sure the spread is not that big of an issue when it comes to options because I assume that MMs usually get a better price than you or I would, and/or it may take a day or more before they loose less (not actually make money) on their overall stock and option position as the option's price becomes profitable. So, if they are hedged at all, at this point, it's probable that their hedge using options has cut their overall loss. Anyway, under normal conditions, MMs can make a killing, but in a bear market, MMs have and do lose money under extreme plunges. Just look at Lehman, Bear Sterns - and "who knows" how many others reported huge losses from their "trading desks". Steve
Very good question ! "Effectively" hedging is an art ! Dynamic Hedging Strategies In this article, the authors use the Black-Scholes option pricing model to simulate hedging strategies for portfolios of derivatives and other assets http://finance.wharton.upenn.edu/~benninga/mma/MiER71.pdf
This is an excellent question and I wondered the same until I read an article some place, I can't remember where now, that during bull markets liquidity providers build massive short positions and during bear markets they build massive long positions by the fact that they provide liquidity. For example, during the dot.com bubble the market makers built massive short positions. Then, at some point when the bubble bursts or the bear market ends, they start reversing their positions until they are squared and along the ways they have earned the spread. This means their viability depends on how fast the market reverses direction and another cycle begins.