How does market makers prevent against adverse selection?

B

beefcaketrade

My understanding is still novice as to the mechanics of market making.

A designated market maker is the buyer or seller of last resort. They stand between buyers and sellers to settle trades as the middle man. So basically, they run a book of stocks themselves with a certian stock inventory, or they will short stocks to settle trades during certain sessions.

A market maker basically ideally never wants to run a net long or short position in a stock. They are not in the business of speculating. They are in the business of making markets and providing a service. This is so called adverse selection, when the market maker holds a net long or short position in a stock that moves dramatically in an opposite direction causing the market maker to have extreme capital losses.

So how do market makers eliminate adverse selection? How do they hedge their positions? Or are there no perfect method and they are always exposed to adverse selection?

Do they spread the risk out then? Have a few market makers each absorbing a certain quantity of stock in case there is adverse selection? I mean, they can use options and futures to hedge positions, but somebody has to be holding the bag down the chain, if in the case of options, again, its the clearing firm in the options house that takes the risk.

Basically its spreading of the risk to different parties? A market maker will use options and futures to hedge out some risk? They will try to keep their own position as close to neutral as possible?
 
Quote from beefcaketrade:
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So how do market makers eliminate adverse selection? How do they hedge their positions? Or are there no perfect method and they are always exposed to adverse selection?
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For the theory, see the references to "adverse selection" in the index of "Trading and Exchanges" by Harris.
 
Quote from beefcaketrade:

My understanding is still novice as to the mechanics of market making.

A designated market maker is the buyer or seller of last resort. They stand between buyers and sellers to settle trades as the middle man. So basically, they run a book of stocks themselves with a certian stock inventory, or they will short stocks to settle trades during certain sessions.

A market maker basically ideally never wants to run a net long or short position in a stock. They are not in the business of speculating. They are in the business of making markets and providing a service. This is so called adverse selection, when the market maker holds a net long or short position in a stock that moves dramatically in an opposite direction causing the market maker to have extreme capital losses.

So how do market makers eliminate adverse selection? How do they hedge their positions? Or are there no perfect method and they are always exposed to adverse selection?

Do they spread the risk out then? Have a few market makers each absorbing a certain quantity of stock in case there is adverse selection? I mean, they can use options and futures to hedge positions, but somebody has to be holding the bag down the chain, if in the case of options, again, its the clearing firm in the options house that takes the risk.

Basically its spreading of the risk to different parties? A market maker will use options and futures to hedge out some risk? They will try to keep their own position as close to neutral as possible?
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Market making left stocks years ago. We have ECN's now. Those bids and offers are mostly customer orders and HFT.
 
Someone told me there are still market makers for crude oil futures. I'd love to know how they deal with the crazy volatility of that instrument.
 
Quote from NoDoji:

Someone told me there are still market makers for crude oil futures. I'd love to know how they deal with the crazy volatility of that instrument.
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Delta hedging.
 
THere are still designated market makers on the NYSE and Nasdaq. Their job is to step in when the market is thin or when there is a big order imbalance.

Obviously they are proprietary and they won't tell anyone how it works unless youre in the industry but I did read some journals about the programming of those HFT market making algos. Their job is to try to churn as much as possible and try to end the day flat without a net long or short position. Then they put in stop losses and shut the program off when adverse selection occurs and the stock moves against them.

So basically my understanding is the external HFT market makers, not the designated market makers from the exchange (even though they too are also algo based and HFT), just do a lot of pointless churning trading day in day out to 'make markets'. ECNs only provide a route to settle a trade by obtaining price quotes. The external HFT MMs basically look at prices from all ECNs and match the buyers with sellers at a super fast speed.

But I'm still talking about adverse selection for designated market makers or floor specialists. These guys basically have to run a net long or short book most of the time right, because they are responsible for particular stocks. So they are exposed to risk of adverse selection as a job description. How do these guys hedge out their risks?

Maybe the MMs engage in options or futures positions. But then that means the CBOE and the clearing members there take on the risk then if the MM exercises options to eliminate a bad position. So basically its all about spreading of risk then? I mean do they even do that? I'm just imagining they could go to the options market.
 
A successful market maker has scale. They have enough non- informed order flow where they are making money that it pays for the informed order flow losses.

It's a hard business.
 
Single stock risk is always there - sudden good or bad news, etc, that someone else knows before you do. The best you can do is diversify across stocks.

Broad market risk like the Fed, up or down markets, etc, can be hedged with other instruments pretty well.
 
To the person that said MMs no longer exist, I disagree the guys on the floor have just been replaced by computers.

So to answer OPs original question, it depends. For example, if you're talking about ETFs creation/redemption or hedging with other instruments is generally the case. For single cash equities, I won't go into specifics here but most people running automated MM type strats will use some kind of function, which could depend on factors such as inventory size, trade size, last bid/ask, etc.., to determine where to quote (i.e. how wide).
 
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