3 ms·

Your intuition is good, I think it's the terminology/semantics that are causing you confusion. What you're describing is a valid way to make money as a trader,

Your intuition is good, I think it's the terminology/semantics that are causing you confusion. What you're describing is a valid way to make money as a trader, but most people don't call it market making. The wider you quote relative to other market participants, the more risk you take on - because your volume is lower, you have to hold on to your positions longer, exposing you to greater fluctuations in price. Market making is very much about not exposing yourself to this kind of risk. In real terms, if you quote a penny wide market, there's a much greater change that you can both buy and sell in a short period of time to capture that penny. However, if you quote a 10c wide market (when everyone else is quoting a penny), you might buy shares at $10, but it might be a much longer time before anyone wants to buy them back from you at $10.10 - in fact it might be never, they could go straight to 0! Again, quoting that 10c spread is perfectly valid, it just means that your edge begins to be less about capturing "flow" as much as it is about predicting the direction of the stock over a longer time horizon.

gas9S9zw3P9c 6y ago
That's a good point and it makes sense, but couldn't you hedge the inventory risk?
- pgwhalen 6y ago
  I'm not totally sure what you mean by "hedge the inventory risk." How would you accomplish that? You can reduce your position size but that's not hedging, it's just reducing your exposure in the first place. You could use options, but that 1) exposes you to other risks and 2) is prohibitively expensive given the cost to transact in that market is much higher. The best way to keep risk low as a market maker is to keep inventory low, which means you need to get out of positions quickly, which means you need to have competitive prices to increase your chance of interacting with order flow.

gas9S9zw3P9c 6y ago

That's a good point and it makes sense, but couldn't you hedge the inventory risk?

pgwhalen 6y ago
I'm not totally sure what you mean by "hedge the inventory risk." How would you accomplish that? You can reduce your position size but that's not hedging, it's just reducing your exposure in the first place. You could use options, but that 1) exposes you to other risks and 2) is prohibitively expensive given the cost to transact in that market is much higher. The best way to keep risk low as a market maker is to keep inventory low, which means you need to get out of positions quickly, which means you need to have competitive prices to increase your chance of interacting with order flow.