So, I've been wondering about this for a while, but how do market makers like Knight determine fair value in equities? How do they decide where to bid-ask and how wide the spread should be? How do market makers decide where a price is cheap? Obviously this is pretty valuable information for any trader. Anyone have any experience on market making firms like Getco or Knight? How do they determine this? I worked as a prop trader for 3 years whose focus was on short-term inefficiencies in equities and ETFs. I am currently trying to transition into fundamental-driven trades and longer time horizon trades. If anyone would like to discuss over PM, feel free. Thanks. I am not asking for proprietary information, I just want an idea of how market makers do their job and determine fair value. If a price drops below this fair value, how much do market makers buy? How far away? How much?
Generally speaking, those firms take advantage of order-flow (bids and offers) & arbitrage opportunities. There aren't many who sit and look for new opportunities to enter positions. Most have setup their trading to take advantage of one small opportunity. A lot of their profits comes from internal routing that comes from outside clients through ECNs and other such mechanisms. Of course, every firm is different, but generally speaking, there aren't many firms like Knight that are successful because of great strategies. It's usually because they can capitalize on some regulatory requirement or some type of arbitrage that somebody seeing that many orders coming in/out can profit off. Just think about how a small mom & shop prop can write an algorithm that goes against their worst traders. All they need is a list of their biggest losers and automate your system to do the opposite for those account #s. There are TONS of these opportunities; however, they usually require TONS of capital to go along with it. The same opportunities are available at prop firms like WTS, that do similar internal volume (about 4 billion shares a month is what Knight or WTS does.) There's no secret formula to profits in the market, nor is there any real structure targeted at protecting smaller investors. It's a dog-eat-dog world and lots of firms make their $$ off taking advantage off the order flow of retail investors and traders. There are thousands of ways to do this, but it fits the old clique, only those born rich will remain that way.
Market makers profit on the spread between the bid and the ask. They can make money all day every day until they make a coding mistake and blow up their company. Not so long ago, you could do this yourself, but now they are able to do sub-penny trades to step in front of your order. They are also able to pay for co-location of their servers to reduce latency. And finally, they pay for being able to look at order flow a second before you can which is front running. So they stole from all the traders and investors who are unable to do this. But, they now fight other computers as most traders no longer compete against them, thereby reducing their ability to succeed.
This is so true and the new HFT laws in Dodd-Frank that are gonna hit are gonna put stress on these type of firms. I could be mistaken here but to me it seems like they're trying to cut off market makers and HFT firms by killing their ability to do these fraction of a second transaction. I don't really see the big deal myself but the average blue-collar american thinks this is the cause or at least a contributor to the shitty economy. In reality, it's the democrats and republicans that have been in charge for so long that have screwed things up for them but it's a pin-the-tail-on-the-donkey type of world we live in today.