What techniques to market makers use to manage operational and 'massive' adverse selection risks?

[brownegg]

I've done a lot of market making in futures. I've been large and active in ES, FF/ZQ, HG, GC, S, etc. For whatever that's worth.

The short answer is, you don't hedge that risk--you just have a way to get the fuck out. Part of being a successful market maker / liquidity provider is having enough edge "most of the time" that you just eat the bad days. They can be very bad, but they're usually not. If the bad ones are wiping out your "profit", then it wasn't profit in the first place, it was luck.

Example: in days of yore, when mini/big gold arbitrage was possible, I would make $1500 fifteen days a month. Three or four days, I'd breakeven. Once a month, I'd lose $5-6k. The loss is not really a "loss", it's the day that buying the bid and selling the offer doesn't work. C'est la vie.

 

[cjbuckley4]

I've done a lot of market making in futures. I've been large and active in ES, FF/ZQ, HG, GC, S, etc. For whatever that's worth.

The short answer is, you don't hedge that risk--you just have a way to get the fuck out. Part of being a successful market maker / liquidity provider is having enough edge "most of the time" that you just eat the bad days. They can be very bad, but they're usually not. If the bad ones are wiping out your "profit", then it wasn't profit in the first place, it was luck.

Example: in days of yore, when mini/big gold arbitrage was possible, I would make $1500 fifteen days a month. Three or four days, I'd breakeven. Once a month, I'd lose $5-6k. The loss is not really a "loss", it's the day that buying the bid and selling the offer doesn't work. C'est la vie.

Thanks for your reply. I appreciate you sharing your experience here. I've never really considered hedging that viable of a way to mitigate risk for futures market making because you'd need to cross the spread, but I have considered quoting in several uncorrelated products to try to spread out adverse selection risk. I've also considered relative value-minded approaches to MMing.

I'm really interested in finding ways to both lower the severity of the bad days with the above approaches and ways to predict adverse selection. I doubt I'm alone in these interests though.

If the examples you gave were real numbers, it's encouraging to know you were successful trading on this scale. 12*(1,500*15 - 5-6,000) is a very respectable living, but I doubt it justified the types of capital outlays that a lot of market makers are making to pursue this strategy. The "semi-pro" setups I've been collecting quotes on could be well within reach though.

When you say "ways to GTFO", are you referring to approaches to lay off risk quickly like @garachen or just knowing when to cancel your quotes?

Thanks again for sharing. It was a privilege giving you your first well deserved "like."

 

[brownegg]

I'm really interested in finding ways to both lower the severity of the bad days with the above approaches and ways to predict adverse selection. I doubt I'm alone in these interests though.

It's not like it's wrong to try, but I've never seen anyone pull it off. Giving the finger (in the large) to adverse selection is basically what market making is about. And the best (only?) way to make the downside smaller is the arms race.

 

[cjbuckley4]

It's not like it's wrong to try, but I've never seen anyone pull it off. Giving the finger (in the large) to adverse selection is basically what market making is about. And the best (only?) way to make the downside smaller is the arms race.

Good to know I have the right idea, I suppose.

 

[Gambit]

It's not like it's wrong to try, but I've never seen anyone pull it off. Giving the finger (in the large) to adverse selection is basically what market making is about. And the best (only?) way to make the downside smaller is the arms race.

Thank you for your comments brownegg. Would you mind elaborating on the arms race? Do you think 20 to 40 us is competitive enough to make any impact?

 

[2rosy]

pick your market. I wouldn't make markets in front month crude oil but would in csos or any rfqs. there are still people in the options pits making markets: grains, meats. on the screen with average software you can't stream quotes on anything but otm without getting picked off

 

[Gambit]

pick your market. I wouldn't make markets in front month crude oil but would in csos or any rfqs. there are still people in the options pits making markets: grains, meats. on the screen with average software you can't stream quotes on anything but otm without getting picked off

Thanks for the input 2rosy. Tt is enough? How about tt nirvana?

 

[IAS_LLC]

CJ,

For what its worth, the open order risk you're talking about has had me a little edgey too. My solution (if you can call it that) has been to be conservative, and only place orders to establish queue position at one book level (usually the top of the book, or the 2nd level... depends on market conditions). I basically run an adverse selection simulation for my entire portfolio before my risk management algos will approve an order to be released to the market. If the simulation results in my risk thresholds being violated, I will reject/cancel open orders and liquidate positions until everything is back in check. This probably results in fewer opportunities to profit, but should allow me to survive more bad days (I hope).

Thanks,
Brad

 

[Gambit]

pick your market. I wouldn't make markets in front month crude oil but would in csos or any rfqs. there are still people in the options pits making markets: grains, meats. on the screen with average software you can't stream quotes on anything but otm without getting picked off

Sorry what is csos?

 

[cjbuckley4]

Sorry what is csos?

i believe he's referring to a Calendar Spread Option.