How do market makers hedge their exposure?

Discussion in 'Trading' started by Paccc, May 23, 2006.

  1. Paccc


    If a market maker got filled at the bid 50 times in a row, he would have a pretty large long bias in the market. Since market makers are not supposed to speculate on directional movements of the market, how do they hedge their exposure?

    Obviously a way would be to take an offsetting position in a derivative, such as options or single stock futures. But doing this would require them to make hundreds of transactions a day just to keep them neutral on market direction.

    If they were dealing with options, one way would be to stay delta-neutral, but this would require many many adjustments and lots of transaction costs. If the MM uses options to hedge, which strike does he pick, and would he chose to buy puts or sell calls?

    I am interested as to how market makers do their work (risk-analysis, hedging, etc) on a realtime basis. Thanks.

    -- Paccc
  2. with the diamonds on their wives hands, whilest they're swimming around their pools in Long Island, and South / Central New Jersey....

    what else?
  3. No MM is going to get hit more than a couple of times on any bid/offer. And they know the order flow...I wouldn't spend too much time worryinb about them, especially these days.

  4. fhl


    How do they know what other mm's order flow is? Especially when it is a high volume stock where the order flow changes quite a bit. Can they decipher when an ecn is being used by another broker a lot easier than us lowly traders? I'm very worried about them.:)
  5. i read that at one time, and this was before the derivatives explosion, the main driver of IBM share volume was options market makers hedging (back when IBM was a big thing).
  6. who creates the liquidity on the ecns? they may be automated, but who?
  7. segv


    To keep it focused, I will restrict this discussion to equity market making. The equity market making landscape has changed drastically in the last few years. Decimilization, lack of liquidity, ECNs, and the rise of algorithmic trading have eliminated most traditional market making positions. In most cases, the quote you see comes from an automated agent using one or more algorithms to provide or remove liquidity. The problem you referred to, the problem of acquiring a large inventory as a result of trading with informed order flow, is referred to as "adverse selection". Some microstructure theorists used to believe that adverse selection was priced into the bid ask spread. While they may have been right at the time, they were certainly wrong as it applies to modern microstructure. The straightforward approach to managing risky inventory is to lay off that risk immediately. In other words, when inventory exceeds a risk threshhold, dump it to the rest of the liquidity in the queue and start over. More sophisticated agents use quotes from highly correlated instruments to drive their quotes in a specific market. For example, using QQQQ or NQ or a combination of both to drive quotes in MSFT or INTC. Finally, prudent market making agents also use derivatives in the underlying or correlated instruments to hedge crash risk. If you are looking for more information, there is ample academic literature on the subject. Terms that will assist your search include "liquidity provision", "adverse selection", "automated trading", "algorithmic trading". To summarize, market making in any product is a risky and often misunderstood business, but there is no free lunch (anymore).

  8. You guys are pointing out the reason we trade 90% NYSE, because of the single location market that can be "read" pretty easily. But the naz is going to start having opening only trades and MOC's at some that will help with following the price movement.

  9. segv


    At the macro level, the NYSE specialist faces the same set of risks as any other market making agent. I disagree in general that the NYSE can be "read" more readily than any other exchange. Then again, I disagree in general that modern markets can be "read" by human beings without automated statistical analysis (Even then, what is that data actually worth? You had the trade or you did not.). The NYSE hybrid market will increase transparency, and it will be interesting to see how the "liquidity pool" concept works in practice over the long term.

    Don, do your traders have access to the real-time NYSE openbook yet? Were you involved in the testing process?

  10. We have the real time open book, and just as important, the Goldmans Sachs "hidden liquidity pool"...which gives us access to shares that most people can never see.

    The reason for trading NYSe at this time, is because of the NYOB which basically buries the ECN's in volume share trades, and gives a good insight into the depth and breadth of the market. When you have dozens of competing MM's with all sorts of order flow in both directions, it makes for some pretty hard "reading" of the direction.

    Going back to my MM days on the Options floor, we had one pit with 20 guys competing with each other, but we still had to honor the best markets quoted....I see the NYSE hybrid working in a similar fashion....I haven't tested the system with LU yet, but my guys seem pretty satisied.

    All the best,

    #10     May 23, 2006