I am not talking about pin risk. What I am thinking is the following: Stock at time t0 has bid 100 and ask 101; the market maker tries to simultaneously buy at 100 and sell at 101; of course, simultaneity is not guaranteed. if the MM bought at 100 and at time (t0+dt) the price has dropped to 90, then the MM can suffer a loss. So, how do the MMs get around this?
Read Chapter 14 ("Bid/Ask Spreads") of "Trading & Exchanges" by Larry Harris. The essence is that (in theory at least) the spread will be set to include an "adverse selection component". "...It allows dealers to recoup from uninformed traders what they lose to informed traders ..."
That book is based on 1990s facts. There are no more uninformed traders. Most were killed in the dot.com crash and whoever survived in the 2008 crash. Everyone is informed well now. If you are not informed well you are finished in 3 months time. They are that vicious out there. This is why you get flash crashes because market makers will only do riskless transactions. What Harris wrote worked in the past when there was a constant influx of retailers that guaranteed MMs recouping losses. Let's get up to date fellows and stop living in the past
An option market maker would look to buy/sell at prices they feel have "edge" and would hedge the bulk of those trades with stock or other options. If that happened quickly before a hedge in the example above, the trader would lose money. Where and how we hedge and then unwind, determines if the trade is profitable, not the individual trade.
With all due respect Bill (as I am a long time fan of your posts), I don't think it's correct to say MMs are involved in "riskless transactions." MMs have to be aware of some representation of VaR and other factors. The spreads can be quoted in such a manner that spread extraction (+offsets like rebates) does offset the loss from the value at risk. Whether most MMs do that or not is a different question, but they almost certainly have some fundamental idea of risk. You can be the fastest, most amazing MM on the planet but you aren't going to avoid adverse selection at least some of the time, so to say MMs are involved in riskless transactions is a stretch. Harris' work is still a reasonable template for beginning to understanding the markets.
Probably the central tenet for being a successful floor trader was always the ability to buy bids, sell offers, and make markets for floor brokers - in essence, you made your bones capturing the bid/ask spread. The speed and efficiency of the electronic markets is what has made the transition from floor to screen so difficult for the vast majority of floor trader types. Market makers can still make a living with a manageable (wide) bid/ask spread. For narrower bid/ask spreads, the market maker will usually require a hedge for his market making in order to survive the risk component. For example, making a market in an option and hedging the risk with a highly correlated analog in the futures or equity market.
Maybe I did not come across well. I don't dispute this is what MMs normally do. All I'm saying is that there is a constant shortage of uninformed players the MMs can rely on to make up losses. During the flash crash, spreads kept widening until bids reached $0.01. This means that on the way to $0.01 no MM was willing to provide liquidity because they probably thought there was no dummy around to lose if prices kept of falling. I still insist that the Harris work is now largely outdated, especially in the face of robots and HFT. Some parts of it are general and have to do with the foundations of the market and as a result won't ever change.
you adjust your bids/offers off your inventory. as long as the market doesnt go in one direction forever you should be ok.
Being a market maker is a form of selling puts. You will have some serious losses and adverse selection, but you hope you have enough random flow where the bid/offer is positive expectation to offset these losses. Additionally, seeing all this flow is valuable information and good market makers can exploit it. If they know who is selling what they might be able to jump on the bandwagon or hedge appropriately. It's a tough job but not without it's benefits.