How does a liquidity provider "earn" the spread?

[short&naked]

Why does one say that a liquidity provider (placer of the limit order) "earns the spread" while the liquidity taker "pays the spread"?

Other than getting at least a partial order filled at an exact price (limit) vs. getting an entire order filled at the market price, I do not understand what one "pays" and the other "earns". Is this just the language that is used?

Could someone please illustrate this?

 

[abattia]

Quote from short&naked:

Why does one say that a liquidity provider (placer of the limit order) "earns the spread" while the liquidity taker "pays the spread"?

Other than getting at least a partial order filled at an exact price (limit) vs. getting an entire order filled at the market price, I do not understand what one "pays" and the other "earns". Is this just the language that is used?

Could someone please illustrate this?

Let’s say that currently
Ask Price = 101
Bid Price = 100
So initial spread is 1.
In the above situation, a trader can go long either using a market order, in which case she’ll go long at the Ask (101), or by placing a limit buy order at the bid (100), and waiting to get filled.
In either case, having filled, let’s say that the Bid then moves up by X.
Bid Price = 100 + X
The trader then exits her long position with a market order, so at the bid price, 100 + X.
What does she make in the case that she entered with a limit order?
Exit price – entry price = 100 + X – 100 = X
What does she make in the case she entered with a market order?
100 + X – 101 = X – 1
i.e. the difference between what she makes in the two cases is the initial spread.
In the former she earns the initial spread. In the latter she pays the initial spread.

 

[Ghost of Cutten]

If fair value is somewhere between bid and offer, then each time you buy at the bid or sell at the offer, you theoretically 'earn' the difference between the fair value and your fill price.

However, in sufficiently liquid markets, competition + adverse selection (i.e. if you get filled, the next ticks are more than randomly likely to move against you) means that if you get filled, fair value is quite likely to be your fill price or something less favourable. In such markets it may not be possible to earn the spread.

There are some markets with designated market-makers, where only they can place resting bids and offers (or the market structure is such that customers go to them, in favour of competing liquidity providers). Earning the spread is much easier here, especially when the market maker has access to customer order flow, first call, better news/fundamental info etc.

There are also illiquid markets with little competition where you can lean on resting size orders, one tick above (or below), and thus skew the odds in your favour. If the next few ticks are against you, hit the resting order for a 1 tick loss. Otherwise, scalp your profit 1 tick inside the offer/bid on the other side. However, competition, especially from HFT/algos, has wiped out a lot of the free money in such markets.

 

[ChaosNSX]

Cutten,

That post took me back to my spread trading days. Right after the dot com bubble years. That used to be a great method, and was so consistent.
A trader would even get the rebates for providing liquidity. Prime brokerages would easily let you lever up 30-1 if you could balance the portfolio, and keep delta neutral.

Now my position methods have much larger time horizons.

Thanks for the trip down memory lane.
The only constant variable in trading is change.

Quote from Ghost of Cutten:

If fair value is somewhere between bid and offer, then each time you buy at the bid or sell at the offer, you theoretically 'earn' the difference between the fair value and your fill price.

However, in sufficiently liquid markets, competition + adverse selection (i.e. if you get filled, the next ticks are more than randomly likely to move against you) means that if you get filled, fair value is quite likely to be your fill price or something less favourable. In such markets it may not be possible to earn the spread.

There are some markets with designated market-makers, where only they can place resting bids and offers (or the market structure is such that customers go to them, in favour of competing liquidity providers). Earning the spread is much easier here, especially when the market maker has access to customer order flow, first call, better news/fundamental info etc.

There are also illiquid markets with little competition where you can lean on resting size orders, one tick above (or below), and thus skew the odds in your favour. If the next few ticks are against you, hit the resting order for a 1 tick loss. Otherwise, scalp your profit 1 tick inside the offer/bid on the other side. However, competition, especially from HFT/algos, has wiped out a lot of the free money in such markets.