How do market makers hedge their exposure?

dac8555 · May 23, 2006

Don is right...they wont get hit more than a couple of times. and it isnt that important

They dont need to hedge, They just back off their bid or offer.

for exapmle, if i am holding 50k shares, and i want to go neutral, i back of my bid and get more competitive on the offer.

as a little piece of education that doesnt really apply to nasdaq as much as other instuments like bonds...if institutions of shares/bonds very quickly...they go to the interdealer market.

thecalip · May 23, 2006

Read "McMillan on Options", he goes into great detail of how it works.

Quote from 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
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Paccc · May 23, 2006

Thanks all for your helpful responses.

Usually we think of MMs making money by taking the spread, but it seems that this would hardly be much if the market is volatile since it could move out of their favor quickly. How then, do market makers make their money?

Also, I have seen software that allows one to act as a market maker by auto-quoting a bid/offer. Some of these were advertised to do auto-hedging and risk analysis. I am curious as to how these programs function, and what types of hedging would be taking place?

Thanks for all your input.

-- Paccc

Paccc · May 23, 2006

I have read that, but he focuses mainly on market makers in the derivative markets. I found his explanation to be very interesting, but it seems that it is more about the theory of it rather than making markets in practice.

-- Paccc

Quote from thecalip:

Read "McMillan on Options", he goes into great detail of how it works.
More...

aPismoClam · May 23, 2006

Quote from 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).

-segv
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i love this sort of high-faluting mentalism. ultimately machines crash and burn when they are expected to act like people. go electronic, but keep the pits nearby.

Don Bright · May 23, 2006

Quote from dividend:

who creates the liquidity on the ecns? they may be automated, but who?
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Please realize that there hundreds of firms executing millions of shares everyday, from many sources. Options traders hedge with stocks, futures traders (program traders) hedge with options and stocks, mutual funds get money daily....and everyone of them attempts to use whatever routing system is showing the better pricing...or they "park" limit orders at various locations based on commission costs, etc.

Don

segv · May 23, 2006

Quote from aPismoClam:

i love this sort of high-faluting mentalism. ultimately machines crash and burn when they are expected to act like people. go electronic, but keep the pits nearby.
More...

Where did you just come from? 1993? Were you in Mexico? I hope the weather was nice. It looks like you are a little late on the whole "electronic vs floor" discussion. While you were away, the NYSE merged with ARCA, the floor of the Pacific Exchange in San Francisco became a health club, and hordes of traders struggled to compete as they moved "off floor" around the world. Machines crash and burn? What do you think an exchange is exactly? Did you notice those little handhelds all of the floor traders seem to be carrying around with them? What do you suppose those little devices are, exactly? Keep the pits nearby? You mean the health club?

-segv

segv · May 23, 2006

Quote from Paccc:

I have read that, but he focuses mainly on market makers in the derivative markets. I found his explanation to be very interesting, but it seems that it is more about the theory of it rather than making markets in practice.

-- Paccc
More...

The theory of market making and the practice of market making diverge pretty quickly. In a single illiquid instrument with a monopolistic market maker, you can think about the return as a function of the bid-ask spread. The reality of modern market making is that the spread is a function of the correlations and volatilities of a huge basket. Market makers do not make markets in only one issue. They diversify the adverse selection risk among a large basket of issues, spread off against derivatives or proxies of that same basket. Again, this is the theory of market making. What components make up the basket, how the components are traded, how the risk is diversified or spread off is the practice of market making. You will not find a lot of literature on the practice of market making. If you have a quantitative or technical background, you can try to get a job at a market making firm to get exposure to the practice on a large scale.

-segv

segv · May 23, 2006

Quote from dac8555:

Don is right...they wont get hit more than a couple of times. and it isnt that important

They dont need to hedge, They just back off their bid or offer.

for exapmle, if i am holding 50k shares, and i want to go neutral, i back of my bid and get more competitive on the offer.

as a little piece of education that doesnt really apply to nasdaq as much as other instuments like bonds...if institutions of shares/bonds very quickly...they go to the interdealer market.
More...

That algorithm works fine when prices are mean reverting. Suppose that you back off the bid, but the bid gets taken. You back off again, the bid gets taken again, and your offer does not. What do you do with the risk? You can lay it off on a correlated instrument, lay it off on a derivative, keep it, or get rid of it. What do you do?

-segv

segv · May 23, 2006

Quote from Don Bright:

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.
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Interesting, Don, tell me more. So Goldman gives clients access to its internal ECN book?

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.
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I agree that there is more liquidity routing to NYSE. The pseudorandom order flow is still there however, you just cannot see it (lack of transparency). That all changes with real-time OpenBook, although you still cannot see the origin. Can you see origins in the Goldman book?

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.
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I moved along to derivatives quite a while ago, but the hybrid market might be an interesting place for experimentation. Maybe I should dust off the old code...

-segv