How do market makers make money?

[tommo]

This is when MM’s get absolutely hosed. I’ve really hurt some MM’s badly when I traded OTC energy. As a Commercial producer I had inside information.

Yup, theres definitely bad days, but its just about managing the variance in your P/L swings. If you make 5k a day 19 days of the month and lose 20k on the last day youre still up money. Whereas more long volatility type strategies lose 1k for 19 days of the month then make 30-40k on the last day. Still make similar money (assuming you know your edge) but exposing yourself to the occasional big hit not by default an unprofitable game.

 

[qlai]

I've worked on market making desks for years.

Which instruments, if you don’t mind sharing?

 

[tommo]

Which instruments, if you don’t mind sharing?

All futures contracts. Equity indexes and energy mostly

 

[murray t turtle]

I know what the spread is but it still doesn't make sense. If there is a stock which is crashing hard then how are they not losing money.

It seems all of you also have no idea how it works - you keep spewing out the same nonsense about the spread but don't actually understand the spread has nothing to do with it.

If they are being forced to provide a bid on a stock that is tanking then that bid will be hammered until the price has lost all of it's gains. So the market maker is left with huge inventory of a worthless stock they have had to buy at a higher cost (as they are required to always provide a bid).

%%
Partly true;
but they tend to be better than average traders/plenty of capital.
WHO says they are left with a huge inventory??Wrong.
[Also every day they can gap it up if they ran a bit short.]Some trade/invest their own accounts like we do.
.Public co for example VIRT/ 64% stock rise yield/better than average yield/eps.900%
Get real dude/as if all market makers/specialists never gap up or down open price////////////

 

[ajacobson]

in products like options - massive leverage with hedged positions.

 

[bone]

The most profitable Market Makers seem to be in the OTC markets - and to do that, it takes really serious capital. Less crowded, more specialized, wider bid/ask spreads, and pure risk.

 

[murray t turtle]

That's because equity HFTs are not market makers in the old sense of that word. Anyone with the right technology can play this game, there is no regulatory obligation of "ensuring fair and orderly market" like in the old times. For example, I make markets in several securities where I have the analytical advantage without being registered as an MM. In options, it's a bit different, as you have to be a broker-dealer and have some compliance burden in exchange for some special arrangements.

Also, in reality, things like flash crashes are so rare that they don't really take catastrophic losses. What really hurts is a breakdown in their models like it happened with Knight. When you're making millions of trades a day, tiny advantage translates to a large profit while tiny disadvantage translates to a very large loss. Both happen way before you know it.

%%
And if we could mostly avoid a flash crash;
have to assume MM could avoid them even more.[I was in a dividend paying etf with about 1 million average volume.i thoght the flash crash IN THAT a bad quote/LOL still looks like a bad quote in hindsight.]NO way I would panic sell that nonsense.
I would have bought more if I could have gotten filled/not much volume on the flash crash.]AND Knight had a model/computer malfunction/max.............................................

 

[brehantoir]

Dr Jon Najarian describes in his book how market makers make money. To make the market he will take a long side on one trade being offered and then immediately has to seek placing an equivalent short trade in either stock or options to hedge off his risk and then keeping the difference of the bid and ask spread as his profit - he describes the mindset as walking out onto a street with bulldozers approaching both side to pick up nickels and dimes and then having to get out the way quickly before getting squashed.

 

[Jonathan Weissberg]

I've worked on market making desks for years. Market makers get paid a fee by the exchange for meetining minimum quoting obligations. Often have to be x number of ticks away from best bid/offer 80% of the month.

Some MM deals you don't get a monthly fee but free exchange fees so the prop side of the business has a bit of an edge being able to trade at lower costs.

The downside is you often get filled on violent moves when you don't want to be filled. The name of the game is to get filled as little as possible and when you do get filled to hedge it off as best as you can hence its mostly all automated.

Out of curiosity, how do you avoid getting filled other than quoting less if you need to sit x ticks away constantly?

And re: hedging it off, is it common for market makers to hedge off automatically into relative value trades or is it mostly pure arb and into the underlying?

 

[volpri]

Dr Jon Najarian describes in his book how market makers make money. To make the market he will take a long side on one trade being offered and then immediately has to seek placing an equivalent short trade in either stock or options to hedge off his risk and then keeping the difference of the bid and ask spread as his profit - he describes the mindset as walking out onto a street with bulldozers approaching both side to pick up nickels and dimes and then having to get out the way quickly before getting squashed.